Throughout 2019, single-family office (SFO) direct private equity investment has surged, and McGuireWoods has shared some SFO best practices around deal sourcing, vetting, due diligence and co-investing. (See recent McGuireWoods alerts “Strategies for the Family Office Contemplating Direct Investments,” “The Rise of Direct Investing By Single-Family Offices,” and “Key Takeaways From McGuireWoods’ 2019 Independent Sponsor Conference.”)
Direct “private equity” investments encompass a broad allocation spectrum from venture capital, to growth equity (often a minority stake like VC) and buyouts (or control stakes). The line between VC and growth equity has increasingly blurred, thanks in part to the migration of technology investors (including corporate VCs and private equity funds) to earlier-stage deals. VC bets typically involve technology and market risk, in addition to the execution and management risks associated with any growth equity or buyout investment. As compared with more de-risked investments in more mature companies, VC’s unique risk-return profile, coupled with the common “people” dynamics and “dilution” sensitivities of early-stage company founders and legacy investors, warrants a different approach to deal due diligence and execution.
Given their unique personal, philanthropic and business legacies, SFOs (both multigenerational and those created by a first-generation entrepreneur from a successful exit) have been making VC investments for a long time. VC investments can be driven as much by an SFO’s mission and desire to make “impact” investments (e.g., biotech, healthcare, education and renewable energy) in the “innovation economy” (think “data,” consumerism, “smart” manufacturing and logistics, and all things artificial intelligence) as they are by financial motivations. That said, SFO VC investments demand a fair potential return for the greater risk. As SFOs become more sophisticated and deliberate in their direct investing strategies, an appreciation for the differences between VC and other private equity bets should enhance the SFO’s ability to manage the additional risks, less predictable outcomes and entrepreneurial culture characteristic of technology-oriented startup and emerging companies.
Due Diligence Dynamics: Technology, Market and Other Risks
The target company in a VC investment will often have the following characteristics warranting a more tailored and deeper dive into certain aspects of the company’s business, operations, capitalization, legal documents and compliance.
|Target Company Characteristics
|Due Diligence Implications
|Reliance on and leveraging of the Internet, data, proprietary and third-party software (including products incorporating third-party provided and open-source components and hosting and online services), and patents, trademarks, trade secrets and other intellectual property
|Engage technology, software and IP experts to review website, data collection, processing and storage (internal and external, including customer-facing websites), software and IP functionality, ownership, security and compliance issues (including past, ongoing or potential IP issues, disputes or infringement)
|Capitalization table includes numerous founders, key employees, angel and strategic investors, and equity, options, convertible notes and simple agreements for equity (SAFEs)
|Confirm accuracy and completeness of records and associated legal documents, including fully diluted capitalization, which accounts for issued and unissued options, convertible notes and SAFEs
|Founder and key employee equity ownership
|Review and consider desired allocation, vesting and repurchase rights
|Outsourcing of product development, testing, manufacturing, and distribution, IT, data management, software and hosting services, and key relationships with vendors, corporate, university and other strategic partners
|Review all arrangements and agreements for impact on business plan, operations and eventual exit, and legal compliance, including review of vendor reputation, capabilities and compliance
|Non-U.S. customers or users or developers of products or software
|Review compliance with export control and technology transfer laws, restrictions and sanctions
|Non-employee and non-U.S. citizen service providers
|Review compliance with tax, Fair Labor Standards Act, employment and immigration laws
Business, technology and market due diligence around product development and commercialization opportunities, risks and challenges should be supplemented with tailored legal, financial and technical due diligence by qualified law, accounting and consulting firms. While no level of VC due diligence will provide any guarantees or a “crystal ball,” the process and findings will provide a critical basis for determining the company’s capital needs and uses, developing a realistic business plan, projections and budgets, and adopting a culture of compliance and reporting, including policies and protocols in the areas of product development, intellectual property protection, financial management and controls, and legal compliance.
Cap Table Concerns: Founders, Helpers, Angels and Strategic Partners
The target company will often have a long list of common (and perhaps some seed preferred) equity holders, option holders and investors holding bridge and convertible notes and SAFEs. The stakeholders will include founders, key employees and angel investors, and may include key strategic investors, such as corporate and university partners.
There is typically significant sensitivity around the potential dilution of the founders and existing investors (from the SFO’s investment, unexercised and unissued options, and convertible securities). Any proposed changes in the founders’ and employees’ equity allocations and any new vesting or repurchase restrictions will usually result in pushback. The conversion or repayment terms of any convertible equity, notes or SAFEs will need to be addressed. New terms or settlements may need to be negotiated with any straight debt or secured lenders.
After reviewing and confirming the cap table and the terms of all options, convertible securities and debt, the SFO can determine what changes will be required to the company’s capitalization to provide the SFO with the share price, fully diluted ownership, seniority and protections it needs. The process is as much a “people” process as a business negotiation, as each of the incumbent stakeholders will have individual hot buttons and the SFO will want to close the investment with satisfied and incentivized founders, key employees and strategic investors and lenders.
Term Sheet Tests: Acting Like a Partner (and Forming a Club)
The VC term sheet is a more “market” (e.g., developed and uniform) part of the VC investment process than term sheets (or the letters of intent) more commonly tailored for growth equity and private equity buyout deals. The term sheet provides the basis for a more efficient negotiation and closing of the transaction. As the SFO envisions and prepares the first draft term sheet, it should do so with any co-investors in mind if the VC investment will be made as a club deal. VC investments are particularly well-suited for club deals because the sponsoring SFO may desire some level of risk sharing, the leverage afforded by “other people’s money,” and additional “smart” money investors to serve on the target company’s board or an advisory committee. One SFO will often lead the club deal, negotiate on behalf of the club special purpose vehicle (SPV), and may even serve as the manager or general partner of the SPV.
Even so, co-investor members of the club may negotiate for a “flow-through” of some of the term sheet rights and protections, in particular those relating to liquidity rights and investor information. And as club deals provide significant risk sharing and additional smart money to the lead SFO, the terms should be negotiated with the likely desires of co-investors in mind.
Depending on the company’s stage of development and future financing needs, the SFO’s (or club SPV’s) investment will usually be in seed, Series A or Series B preferred equity. Regardless, the National Venture Capital Association model form of Series A term sheet can be a good starting point for drafting the proposed term sheet, as it is considered reflective of market terms, is investor friendly and will be familiar to the lawyers.
It is important to note that what may be market for any particular investment term as applied to a fictitious startup and a VC fund sponsoring a Series A round is seldom appropriate for an SFO investing in a real company with its own risk profile, strengths and weaknesses. So while the model term sheet is an effective selling and transaction management tool, the SFO should be prepared to explain how its first draft term sheet is appropriately tailored to the target company and its investment objectives. This selling effort is a critical point in the people and relationship-building process, and if the SFO has established a level of trust with the company stakeholders as to its value as a partner in the company’s development, growth and exit, it should be able to negotiate terms that fairly reflect the company’s development and commercialization stage and risk, potential future capital needs and other company-specific issues.
The following is a list of the terms that typically receive the most thorough consideration by the SFO and warrant the most delicate messaging to the target company, including which alternatives are perceived as more market and the areas in which compromises can be negotiated. Of course, the best outcome on any particular term will depend on the whole package, and there will always be opportunities to trade less-critical terms for ones that may ultimately matter. Note that the “compromise or give” suggestions are for illustration purposes only (as examples of a typical negotiation), and the particular company profile and issues may dictate more or less company-favorable outcomes.
|Term Sheet Term
|Compromise or Give
|Company cap table reset and conditions to SFO investment (company may need to be converted from an LLC to a corporation or to an entity governed by Delaware law)
|Convertible notes and SAFEs convert to common, and pre-money valuation includes additional 15 percent option pool for future hires
|Convertible securities convert to SFO’s class of preferred, and new options dilute legacy stockholders and SFO
|Convertible securities convert to preferred, which is junior to the SFO’s preferred, and 10 percent additional option pool dilutes legacy stockholders
|Full investment up front or staged in tranches based on milestones
|1/3 at closing, 1/3 upon achievement of development milestone, and 1/3 subject to certain financial conditions
|Entire investment funded at closing
|50 percent at closing and 50 percent as of specified date subject to certain minimum progress and financial conditions
|Preferred equity dividends
|8 percent per annum cumulative dividend payable in equity (PIK) upon conversion or company sale or liquidation event
|No preferred dividends; otherwise, paid on as-converted basis if paid on common
|6 percent cumulative payable at company’s option in cash or PIK upon company sale or liquidation event
|Preferred liquidation preference payable upon company sale or liquidation prior to common
|1.5x preferred price increases to 2.0x on certain future dates (liquidation preference multiples are often not well received, but in many SFO “rescue” scenarios they are necessary to make the return modeling work)
|1x increasing to 1.5x based upon milestone failures
|Non-participating preferred (SFO gets the greater of its investment or as-if-converted to common amount upon sale or liquidation) or participating (money back plus participation) or participation with cap (money back and participation capped at multiple or internal rate of return)
|Fully participating (no cap)
|Participating subject to 3x investment or x percent internal rate of return cap
|Board and SFO director seats
|Board of seven, three SFO (club) seats, one CEO, two common seats, one independent approved by SFO
|Board of three, one SFO, one CEO, one common
|Initial board of five, two SFO, one CEO, two common seats, with ability to increase to seven with two independents approved by SFO directors and common directors
|Investor protections or veto rights
|Standard list of transactions plus approval of technology transfers, strategic partnerships, debt, annual budgets and hiring and firing of key executives
|No to these inclusions (all subject to board approval)
|As bid, but debt, budgets and hiring and firing subject to consent of board, including one SFO director
|Narrow-based weighted average (versus “full ratchet,” and option pool excluded)
|Pay-to-play resulting in loss of anti-dilution protection if SFO does not invest in future round
|Broad-based weighted average (unissued option pool included); no pay-to- play
|Investor liquidity opportunities/rights
|Preferred subject to redemption (“put” option by SFO) in five years, demand registration rights, and right to put company in sale process upon certain events
|No redemption rights, only “piggyback” registration rights, no forced sale rights
|Agree no redemption, no demand registration, but sale or “drag-along” right exercisable by majority of preferred and board approval
|Investor information rights
|Audited annual and quarterly financials, annual budgets and annual cap table
|Unaudited annual financials
|Annual (audited in second fiscal year after closing), quarterly unaudited, budgets and cap table
|Founder/key person vesting and buyback
|Company right to buy 100 percent of founder or key person common at cost (or zero) if leaves in 12 months, then right lapses in monthly increments over next 24 months
|Company right to buy back 25 percent of founder stock at cost and 25 percent at some fixed value if leaves in first 18 months; 50 percent of other executives at cost in 12 months, subject to lapse over next 24 months and “double trigger” vesting or stock escrow that incentivizes key people to remain for some reasonable period following a sale
|SFO can force sale process approved by board
|Majority of all stock voting as one class
|Majority of each of common and preferred voting as separate classes
|Pre-emptive rights or right of first refusal
|Standard pro rata with over-allotment rights
|Standard pro rata with no over-allotment rights
|No shop and fees
|90 days; company pays specified amount of investor fees
|45 days; no fees
|90 days; fees unless SFO withdraws
SFO direct VC investments require industry and technology knowledge, familiarity with market terms, a reasonable measure of risk tolerance, and a focused process around due diligence, cap table resets and modeling, and terms that balance founder and stakeholder sensitivities and incentives and SFO return objectives. Terms that are market for one company or an institutional VC investor will rarely achieve this desired balance. Through an open and honest dialogue, information exchange and relationship-building process, SFOs can more successfully identify, verify and execute successful direct VC investment deals.