Aerospace Investment: Confidential Instructions for Venture Capitalist

CONFIDENTIAL
Negotiable Terms for the Venture Capitalist

The following confidential information regards eight negotiable terms you will discuss
with the founder.3 The terms may be negotiated in any order. A confidential score
sheet is also included, which breaks down the specific point values for each term. Use
this score sheet to record the agreed terms of your negotiation and to calculate your
total score. For the purpose of this simulation, you must abide by the scoring
restrictions.

The point values for each term are based on the totality of Aerovent Capital’s
investment interests, e.g. industry analysis, risk profile, portfolio composition, etc. Note
that if the specified minimum terms are not agreed upon as outlined in the instructions
(unacceptable terms are reiterated as “No Deal” on the score sheet) or the substantive
BATNA is not reached, you will not proceed with the entire investment. Do not show
any of your confidential instructions to the founder.

Term #1: VC Equity Percentage

You will receive equity in Earth Escape for your $100 million investment. One of your
most basic interests in this negotiation is to receive as great an equity percentage as
possible. In your previous meeting with the founder you both agreed that a $100
million investment is the appropriate amount to help Earth Escape reach the next stage
of its development, a cash flow positive business running a small fleet of suborbital
RLVs.4 To determine the approximate percentage of equity your investment is worth

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you have considered your valuation of Earth Escape. The equity percentage and
valuation are related such that the higher the valuation you attach to the company, the
smaller the equity percentage you will receive for the fixed $100 million investment. 5

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Determining the value of a company in its early stages can be a subjective analysis.
With Aerovent Capital you have found that detailed financial projections of startup
companies are of secondary value to experience and recommendations from industry
contacts and consultants. By forecasting a range of values for Earth Escape five years
from now and discounting them to the present, you think that Earth Escape deserves a
post-investment valuation between $150 and $200 million. These valuations suggest
that you should receive between 50% and 67% of the company equity for your $100
million investment, but you would be eager to receive even more.6 You justify the
higher equity percentage by considering your desired risk/reward ratio. The unproven

3
Additional terms of the investment will not be considered during this negotiation. For the purpose of this
negotiation it can be assumed that any terms not scored will be in accord with Aerovent Capital’s standard
term sheet.
4
If extremely attractive terms are reached you might be interested in investing more capital. However, this
investment (as is) would be the largest to date for Aerovent and you do not have the resources to invest
more than $100 million at this time.
5
Valuation in this sense refers to “post-money valuation” and relies on the venture capital industry
standard of assuming all stock issued is common stock for simple valuation purposes.
6
Assume percentages of the company are on a fully-diluted basis post-financing.
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Aerospace Investment: Confidential Instructions for Venture Capitalist

management team, uncertain future of the public space travel market, unrefined
technology, and potentially illiquid nature of the investment all support your receiving a
large portion of the company to offset the high risk factors.

One other significant consideration you should make during the negotiation of your
equity percentage is who will have the majority of shareholder control.7 As a legal
matter, though a business corporation is run by its board of directors, a majority
shareholder has the ability to take control of the company.8 Thus, if Earth Escape begins
to fail, there is an importance difference in the influence Aerovent Capital would have
over the company if it owns 51% versus 49% of the equity. You want to make it clear to
the founder that you do not intend, nor desire, to control the future of Earth Escape
through shareholder influence. However, having a shareholder majority offers you
significantly more security in the event that the company begins to fail and Aerovent
must take on a more active role.

Therefore, you have a strong incentive to settle on an equity percentage significantly

over 50% by establishing a low valuation based on your idea of fair compensation for
the substantial risk involved in the venture.9

Term #2: Type of Stock

You must also agree on the nature of the security you will receive for your investment.
You are considering three forms of stock for your equity share: common, convertible
preferred, and redeemable preferred.10 This is an important term for you because it
affects your risk and the proceeds you would receive in a liquidation event.

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The most basic option is common stock. If you are issued common stock you will be
placed on an even footing with the existing shareholders without any liquidation or
conversion preferences. As a respected venture capitalist, you find it laughable to
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consider not receiving some type of preferred stock given the amount of risk associated
with this investment.

The industry standard for venture capital investments tends to be convertible preferred
stock.11 If you were issued convertible preferred shares, in the event of a liquidation
your preferred shares would entitle you to recoup your investment before holders of
common stock receive anything. Additionally, you would have the option of converting

7
Earth Escape’s bylaws detail that for governance issues requiring a shareholder vote, a simple
shareholder majority is required for approval. Regardless of the type of stock agreed upon in Term #2,
Aerovent shall have votes representative of the Term #1 VC Equity Percentage and shall vote as a class
with all holders of preferred and common stock. Note that you will negotiate your representation on the
board of directors as a separate term.
8
See Bartlett, Joseph W. Fundamentals of Venture Capital. New York: Madison Books, 1999.
9 You may use the company’s valuation to negotiate this term, but settle on the specific equity
percentage for the venture capital firm.
10
At this point all shareholders have been issued common stock.
11
See Cardis, Joel, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and
Practitioners. New York: John Wiley & Sons, 2001. p. 198.
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Aerospace Investment: Confidential Instructions for Venture Capitalist

your preferred shares into common stock.12 With this option, in the event that the
value of your equity percentage exceeds the value of your investment, you would
convert your preferred shares into common stock. This option allows you to protect
your initial investment with the benefit of sharing pro rata in the upside potential.

Redeemable preferred shares would be the most favorable to you.13 Like convertible
preferred stock you would have a liquidation preference that allows you to recoup your
investment before common shareholders receive anything. The additional benefit of
redeemable preferred is that in the event the company is worth more than your initial
investment, you are allowed to fully redeem your initial investment and then also split
the remaining proceeds above your investment with the common shareholders pro rata.
Thus, you are not choosing between recouping your investment and sharing in the
equity. Rather, you may do both. Redeemable preferred shares are your first choice
because they best compensate you for the risk you are taking.

Term #3: Dividends

You may also negotiate the right to receive dividends on your equity share. Potential
dividends will not be paid in cash. Rather, they shall accrue until a liquidation event and
be paid in equity, commonly referred to as payment in kind. Negotiate dividends as a
percentage per annum of the original VC owned equity.14 Your primary interest in
agreeing to dividends is to increase your equity share and thus, your upside potential.
From your experience, the industry average, when dividends are issued, is 8% per
annum. You value receiving dividends rather highly because you realize the substantial
increase in your final equity stake a moderate compounding dividend can produce over

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a number of years. You would like to receive as high a dividend as possible without
damaging the relationship.

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Term #4: Antidilution Rights
You would like to negotiate an antidilution provision in the term sheet to protect your
equity share from excessive dilution in future rounds of financing.15 The provision you
will be discussing with the founder is your right of first refusal. If Earth Escape requires
additional capital in the future, the right of first refusal would give Aerovent the right to
buy the additional shares of equity before they are offered to another party. You would
prefer to have this provision in place because it allows you to protect your equity
position from dilution by future investors. This provision could be extremely important
if Earth Escape requires more funding at a later date, but can only negotiate the funding
at a valuation lower than the valuation you invest at. You are hopeful that the founder
may even agree that VC antidilution rights are beneficial to both parties in the long run.

12
Assume a one to one conversion ratio.
13
Redeemable preferred stock would be issued along with common stock equal to the agreed upon VC
equity percentage.
14
Assume cumulative annual compounding of dividends.
15
Dilution refers to a reduction of your fractional ownership of the company.
Copyright © 2007, 2010, 2019 by the President and Fellows of Harvard College. All rights reserved. (Rev. 06/19) 7
Aerospace Investment: Confidential Instructions for Venture Capitalist

You must negotiate this term as either “VC Right of First Refusal” or “No Antidilution
Rights.”

Term #5: VC Appointed Board Members

Achieving adequate representation on Earth Escape’s board of directors is critically
important to your investment. Not only does it offer you influence over the company’s
strategy, but it is one of the principle ways you hope to add value to the company. The
board of directors has many responsibilities that effect the future of a company, such as
setting strategic goals, reviewing management’s performance, approving major financial
transactions, etc.

You are negotiating the number of directors that Aerovent Capital may appoint to the
board. The board currently consists of three members: the founder and two
independent directors selected by the founder. You emphatically want to appoint at
least one member to the board, but the more you appoint the more influence you
would have over Earth Escape.16 If the founder is receptive to Aerovent appointing
multiple board members, you would like to appoint as many as possible for the benefit
of the company and your investment.

Term #6: Vesting of Founder’s Shares

You believe the founder’s vision and technical expertise are critical to the success of
Earth Escape. Vesting the founder’s shares of stock is a way that you can entice the
founder to stay with the company. If the founder’s shares are vested, the founder’s
equity stake would be returned to Earth Escape and each year the founder stays with

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the company a portion of the equity is given back to the founder. Assume that the
founder would receive an equal percentage of equity back each year and will be fully
vested after staying the number of years agreed upon. You are not sure of the
founder’s intentions at this point, but you are positive that if the founder left the
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company in less than four years it would be a disaster for your investment. Four years is
the minimum vesting schedule you will accept. Every additional year further secures
your investment.

Term #7: CEO Replacement Provision

Though the founder is critical to the success of the company, as the company expands
you think it would benefit everyone involved if the founder served on the board of
directors and Earth Escape hired a professional CEO. The founder has acted as CEO
since the company’s inception and has done an excellent job to date considering that
running an entire company is a markedly new experience for a former R&D manager.
However, the CEO is one of the top variables in a company and the attributes that make
a CEO successful in an entrepreneurial company can be drastically different from those
that make a CEO successful in a mature company. Personally, you would like to bring in
a professional CEO immediately to begin implementing the next major stage of growth

16
Decisions made by the board rely on a simple majority approval. Split decisions are broken by the
chairman of the board.
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Aerospace Investment: Confidential Instructions for Venture Capitalist

for Earth Escape. However, your previous discussions made it clear that the founder is
adamant about remaining CEO, and you believe the deal will not proceed if you request
an immediate replacement.

To protect your investment interests and allow the founder a chance to retain the CEO
title, you have suggested the use of performance benchmarks. If an agreed upon annual
benchmark is not met, Aerovent Capital will have the right to immediately replace the
CEO with no further negotiation. Vesting of the founder’s stock would not be affected
by a CEO replacement if the founder continued to work for the company as a member
of the board of directors, which you sincerely hope would be the result.

For this term you are negotiating the performance benchmarks that will be used to
determine if the CEO should be replaced. You have suggested that the benchmarks be
the very revenue projections that the founder presented to you in your first meeting.
The founder presented three potential scenarios categorized as conservative
projections, moderate projections, and aggressive projections. The scenarios detailed
annual revenue projections for the next five years. You are most interested in agreeing
to the aggressive projections because the founder will likely not be able to meet them
year after year, in which case Aerovent would have the option of replacing the founder
as CEO. If the founder is capable of meeting the aggressive projections, so much the
better for your investment. The moderate projections would be acceptable, but you are
extremely hesitant to accept the conservative projections as benchmarks. If only the
conservative projections are met, you will not achieve your required rate of return on
the investment.

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Term #8: No Shop Provision
A “no shop” provision would prevent the founder from shopping the deal around to
other VCs in an attempt to negotiate better terms before the formally binding Stock
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Purchase Agreement is signed. If the no shop provision is included, Aerovent Capital will
have the right to exclusive negotiations with Earth Escape for sixty (60) days, after which
the provision will expire if the Stock Purchase Agreement has not be signed.

You aren’t sure if other firms are interested in Earth Escape at this point, but you realize
the devastating effect even one misinformed VC can have if it offers overly generous
terms. From your experience you have seen deals easily spin out of control when
multiple VCs begin offering competing term sheets, with valuations doubling and all
leverage going to the entrepreneurs.

For those reasons, the no shop provision is an important term for Aerovent. Without it
you might have to renegotiate all the other terms, and you might even have to walk
away from the deal if overbidding occurs. You hope to make it clear to the founder that
the no shop provision is not intended to be detrimental to Earth Escape. Though other
VC firms might offer the founder a higher valuation, they cannot match the value added
that Aerovent Capital provides its portfolio companies through its close working
relationships. You must negotiate this provision as simply “included” or “not included.”
Copyright © 2007, 2010, 2019 by the President and Fellows of Harvard College. All rights reserved. (Rev. 06/19) 9