Edward Lopez and John Stevens - Universal Mobileapps

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In the scenario that UMA’s final terminal value is larger than 25M, both VC will choose to exercise their conversion rights and the return to entrepreneurs will simply be their share of the total exit payoff. There are two major factors determining the ownership share left for the entrepreneur: option pool and valuation. As the ‘fully diluted post money option pool' is set within the pre-money valuation, the entrepreneur’s share will be diluted disproportionately in contrast to the venture capitalist. Assigning a smaller proportion of valuation to UMA, along with the higher option pool, Top Gun only leaves the entrepreneur with 26.61% ownership. Even though Red Baron only proposes a relatively larger proportion of valuation to UMA, the entrepreneur can hold 41.16% ownership with a much smaller option pool. Hence, in the upside scenario, UMA will be in a better position with Red Baron.

Dividend: Both VC request for dividends: TGVP requests for a 8% non-cumulative dividend in preference to dividends on common if declared by the boards while RBVP proposes a more favorable term, a dividend paid on as-converted basis. Generally, Dividend distribution is rarely requested during the early age, as VCs seeking for long-term tremendous payoff will reinvest any profits to support the company’s fast growth. With an optimistic scenario, TGVP might succeed to declare their dividend right before their conversion and decrease the entrepreneur's return payoff by 4M*8%=0.32M, a relatively minor impact.

Missing Terms of the Term Sheets:

Given the fact that entrepreneurs are not familiar with these terms, Top Gun does not clearly state the capitalization items though entrepreneurs can do it by themselves. They miss the term of vesting, employee restrictions and more protective provision of life insurance on founders. Top Gun mentions about voting rights but they do not include the specific actions that will require the consent of holders of a majority of shares. Moreover, they miss the term of the right to participate pro rata in future rounds, as all major investors shall have pro rata right based on their percentage equity ownership in the company.

In both term sheets, they do not indicate the specific targets of option pools. They miss the provisions with regard to voting rights of common stock shareholders. They miss the Staging of Payments as staging resolves the agency conflicts and minimize agency and monitoring costs. They should talk about the term of dismissal of founders including buyback rights and conditions under which founders can be dismissed from the firm. Moreover, both term sheets do not mention the terms of termination. If the firm exits through IPO, all rights under the Co-Sale and voting agreements shall terminate upon an IPO.

Scenarios in Cases of Liquidation Event:

The liquidation preference determines how the pie will be sliced on a liquidation event. If the company runs into trouble and file bankruptcy, the liquidation preference is designed to protect VC’s original investments.

Top Gun: With a liquidation preference of 2, the company needs to give Top Gun $2 per share for each preferred stock they hold. In this case, before the entrepreneurs get anything, Top Gun gets 2*4,000,000=$8,000,000. This means if the valuation drops below $8,000,000, the entrepreneurs will get zero returns.

Red Baron: With a liquidation preference of 2.5, the company needs to give Red Baron $2.5 per share for each preferred stock they hold. In this case, before the entrepreneurs get their payoffs, Red Baron gets 2.5*4,000,000=$10,000,000. This means even if with the current valuation ($10,000,000), entrepreneurs will not receive anything in the incident of bankruptcy.

Terms of Possible Negotiation:

Given the terms listed on the term sheets, there are several things that the two entrepreneurs could argue upon to protect their rights and enhance their profitability. The fact that the two founders are receiving two competing offers from two elite VC firms, they do have greater power and potential in terms of terms negotiation.

Board of directors: Top Gun has entitled and proposed Andrew Liekerman to be one of the three boards of directors to be represented on behalf of TGVP, and one of the directors shall represent the company as the CEO. Future board members have to be both approved by TGVP and the founders, which means that they are unable to appoint a member in their interest. In order to retain for more control over the board, the founders may wish to negotiate to increase the number of board members on board so that they have more influences over the company in the future endeavors. The founders may also wish to negotiate over the provision terms in terms of the entrepreneur’s voting rights, as there are no specific clauses in both term sheets to protect the founders’ rights in board meetings. Especially in the term sheets offered by Top Gun, it only left founders with minimal influence in the board.

Liquidation preference: The liquidation preference that Top Gun proposed is for Series A preferred stockholders to receive twice the original issue price per share and the terms proposed by Red Baron is for the Participating Preferred stockholders to receive an aggregate of 2.50 times the original purchase price. Those terms imply that the proposed valuation of the company is likely to be unjustly low, as the investors and VCs will be getting a higher piece of value created by the company. What the founders could argue on with the VCs is to set a cap on the participation amount, setting a limitation to restrain the investors from sharing the rest of the distribution amounts are being shared between the common stockholders.

Conversion Features: If the founders are confident and optimistic about their company and its future growth potential, they can also discuss for a high conversion ratio for the Series A Preferred to common stock in exchange for other favorable terms. If VCs are also holding optimistic attitudes towards the company’s prospect, they are likely to agree upon such terms to fully exploit the upside payoff.

Option pool/ Anti-Dilution Clause: The founders may also want to discuss further on the terms in the option pool, especially with Top Gun. As the option pool that is open to employees incentives are processed before signing the VC contract, only the entrepreneurs shares get significantly diluted. With Top Gun holding around 44% of the total shares with 25% set option pool, the entrepreneurs would only be left with around 27% of the total company shares. Even though the percentage shares are little better in the terms