#267: Term Sheets 101 with Giannuzzi Lewendon

18:06Adam Marsh:Yeah. So like you're doing a safe financing, a convertible note financing, frankly, I think it's a bit of an overreach to ask for a board seat. It's when this investor's writing a substantial multimillion dollar check, you're doing a series seed or a series A, it's kind of inevitable at that point when you have a lead investor who's really putting some substantial backing behind the company where they're going to ask for a board. So yeah, I don't think that's unreasonable. The founders should always be thinking about maintaining control of the board for as long as possible. So for an early stage company, maybe you're doing your seed or A, someone's writing you a two, three, five million dollar check and they want to see on board.

18:43Adam Marsh:Great. Let's give them a seat on the board. It's a three-member board. The founder or founders appoint two. The investor gets one seat. And then the next round where we're doing our A or our B, the board is inevitably going to grow because someone else is going to write a$5 million check. And they're going to want to say on the governance of the company. But let's expand that board again to make sure that the founders still control. So let's expand that board to five. And there's three founder appointees, one for each investor. But that way, you're still maintaining control. And that's why going back to our initial conversation, I love presenting the term sheet to the investors because we can dictate the terms.

19:19Adam Marsh:We can dictate the size of the board. So as long as we can, let's maintain control of the board. And then observer, right, is a great way to kind of breach maybe some differences. So if they want, the investor comes in, say, we want two board seats, right? But they're already writing a million or $2 million check. So maybe what's fair, a way to meet in the middle is give them one board seat and give them an observer seat. And an observer, like they attend board meetings, they get all the same documents, but they're just not entitled to vote on it and everything. So that's often a good compromise when the investor might be asking for more or potentially overreaching, throw them an observer seat.

19:57Adam Marsh:The boardroom gets a little bit bigger, but it can still be manageable that way. It's so interesting to think about. By the way, if somebody comes to you guys and they're like, yeah, I like what you're saying. I would like to be sending them my version of the term sheet to try to get ahead a lot of these asks that they might make and just make sure we just have it in our framework. How long does that actually take for you guys to do with a brand? If they're like, I know also like, hey, there might be an issue with how they're structured or something where you have to like fix some stuff first to be like ready to actually receive the investment.

20:27But let's just say for the moment that they're ready for it, is that a relatively quick process? Like you need to take time with them and understand their preferences and how they're going to business. And then you can churn out a term sheet relatively quickly or is it like a really long process?

20:41Adam Marsh:It's pretty quick and easy, to be honest with you. Generally, we have a call with them. It's an hour long call. We go through what they see as a priority. We go through our years and decades of experience and time of telling them the pressure points and sensitivities and what companies of their size should expect. And then putting together a term sheet, that's a few hours work on our end. And fortunately, all we do is this. So we've become pretty efficient at putting those together. So it can be done fairly quickly. Of course, on the back end, you might need to do a little diligence as the company to understand the structure of their cap table and all that stuff.

21:17Adam Marsh:But putting together a term sheet, pretty basic stuff. Of all the things that people work with you guys on, it feels to me like that might be one of the highest ROI ones for them is just taking the time to do that properly. So, Gabby, one thing I wanted to ask you a little bit about is, like, what is the difference between economic ownership and control? Because I know there's a lot there.

21:38Gabrielle McGonagle:Yes. And I think there's a fixation on ownership that I think is sort of misplaced because control is really what dictates how things work down the line. I think whether you're an LLC or you're a corp, sort of the starting position, and this is the case sort of as long as you're doing a common round financing or you're doing friends and family or a pass the hat round. In those instances, before you get real negotiated documents, more or less, you can make these material company decisions like a sale, like a financing, those sorts of things with just a majority. And so in those instances, the ownership may be more in play.

22:17Gabrielle McGonagle:Once you're getting strategic investors, private equity, any preferred raise, there is a shift because the majority of ownership alone is not going to control. You're going to have those protective provisions that we talked about. You might have specific things like you can't amend an operating agreement without the investor's consent or without the majority of the preferred's consent. And so the further you get, the more money you take on, the further away you get from an ownership alone being material. That said, obviously, you still want the majority of the common or the majority of the preferred.

22:54Gabrielle McGonagle:You want the fastest path to get those things, right? The last thing you want is you're trying to do a financing. You need a majority of the Series A to approve. and you have 100 different Series A investors and you're having to claw back, get approvals from a bunch of different people. So it's not that ownership is irrelevant. Obviously, the tighter the cap table, the more ownership you have as a founder and as a common shareholder, the better, especially economically, like you talked about before. The last thing you want is to sell the company and own like 1 % of it. But it's important not to lose sight of the control that happens outside of the ownership percentage.

23:30Gabrielle McGonagle:And like we've talked about, But that usually comes in the form of those protective provisions, the board seats and potentially like a liquidation preference where the control and the class of shares matters more than the overall ownership percentage. Maybe we could just jump into that a little bit more about like the class of shares as well, because this is another one where I feel like it's so poorly understood by people, including me. Can you just talk a little bit more about like liquidation preference? Because I feel like this is one that people just don't spend enough time on where even if you're just like an employee, honestly, at a company, like you really want to understand this because I feel like this is often the thing that means you either get paid out or you don't get paid out.

24:12Gabrielle McGonagle:Yeah, so I think people typically think of it as common versus preferred. And preferred sort of sits on top of the common in a sale scenario where there are proceeds being distributed out, which means usually the preferred investors are either getting their money back or they're getting some other benefit. And I think this is where the nuance is, there is non-participating preferred, and then there is participating preferred. A non-participating preferred basically means the investors are going to get either their money back or their percentage ownership. So if an investor invests$2 million and they own 10 % of the company, and then when they go to sell the company, they could either get$2 million back or 10 % of the company represents$5 million, then they'll participate based on their ownership percentage.

25:00Gabrielle McGonagle:So they'll get the$5 million back instead of the$2 million. A participating preferred is sort of both. They get their money back plus their ownership percentage. So in that scenario, they would get their$2 million back, and then they're going to get 10 % of whatever the remaining sale proceeds are. So the participating preferred just sort of has that double dip component, which is even more dilutive to the common shareholders, to that founder group. For me, that sounds like one of these sharky Mr. Wonderful deals. Like, yeah, you're going to pay me back like$0.10 on every unit until I get my money back.

25:34And then I own most of your company also after that. Who actually gets to do the participating version of that?

25:42Gabrielle McGonagle:Yeah, the good thing is it's not common. I mean, I would say like 95 % of our deals, if not more than that, are non-participating. We typically see a participating preferred more in a distressed scenario and where the investor is really taking a gamble and also will be putting a lot of its own resources into helping build the business. as opposed to a check writer who might be providing some consulting services and maybe like assisting and weighing in in important ways, but not taking over that control level. So the participating preferred, again, a rarity. When you first hear preferred, you shouldn't be spooked and think that's what you're getting into because more likely than not, it's going to be a typical non-participating preferred, which just gives the investor assurance of downside protection as opposed to a double-dipping situation.

26:30Gabrielle McGonagle:So that's far and away the Mork-Faman construct. Okay, very interesting. And Adam, I wanted to ask you also, because it's not necessarily something in the term sheet, but I think it's very interesting for anyone listening to this. Can you talk about the option pool? Because sometimes when the liquidation preference is gonna come into play, you're gonna have employees who have shares and often their liquidation preference is way below anyone who invested in it. And maybe if it doesn't sell at some huge valuation, sometimes those employees, because of their liquidation preference, don't end up getting money.

27:04Can you just talk typically about how the option pool works in general?

27:08Adam Marsh:Yeah, totally. And to one additional point of what Gabby's talking about, the one thing we do see with liquidation preferences, they'll be non-participating, but sometimes they'll ask for a 1.5x or a 2x, which dovetails into this conversation. Because if you have a 2x or a 3x, maybe it's even less likely that these option holders are going to participate. So to your question, Daniel, an option pool or equity incentive pool, it's simply like a portion of the company's equity that's reserved for employees, directors, service providers, advisors. I mean, almost every company in the CBG space will need a pool at some point.

27:45Adam Marsh:Typically, it's 10 to 15%. And Gabby Krupp, if I'm wrong, I think when we sold BodyArmor for$8 billion, it was like 25%.

27:53Gabrielle McGonagle:A little higher. I think it was in the low 30s.

27:55Adam Marsh:So there's no right or wrong, clearly. And then the question is, when you get the term sheet on an option pool, is that established on a pre-money basis or on a post-money basis? If it's done on a pre-money basis, that means that only the existing investors and the founders are going to get diluted by that pool. So post-money basis, that means the new investor along with the existing investors and the founders are getting diluted. And we always try to push for that because, in essence, that's kind of more fair, right? So the investor puts in money, he gets diluted by the pool, and then you hire a rock star CMO who gets a percentage of the company.

28:31Adam Marsh:That investor is benefiting from that new hire, that new CMO, who's going to take the company from X to Y. So we always try to push for that because, in essence, that seems more fair. If that CMO had been at the company for three years, then maybe it's fair that they're not really participating in that upside. But if it's a new pool and a new hire and get a new marketing director and a vice president of finance, they're benefiting from all that. So they should suffer that dilution just like everybody else. OK, that is very good to be aware of. By the way, probably a lot of people listening right now who are drinking this in.

29:05If you want to chat with these guys, this is what they do for a living. We'll make sure we put their emails in the show notes here. If you want to reach out to Adam or Gabby or anyone at GL, they'll be happy to talk to you about this stuff. I really want everyone to think about this stuff carefully because I feel like this is one of those no-brainer areas where it really makes sense to work with somebody who's done this before. You can hear everything that they're talking about right now. They have lived this. They have seen it. They know what can go wrong. In a lot of these instances, they work with a lot of VCs.

29:36They work with a lot of brands. They understand both sides of this. So definitely recommend a chat with them. I know they always get hit up a ton after these episodes.

29:44Adam Marsh:Yeah, don't be shy. Like we literally represent companies that are pre-revenue, that are just an idea. And we represent companies that are doing$100 million revenue and everything in between. So we're more than happy to get on a call, even if it's just to pick our brain for 30 minutes. We love the CPG space. We wouldn't be here without the people listening, right? So we're more than happy to help. All right. Gabby, let me ask you a specific question. about redemption rights. Can you talk about that a little bit and why they can be so important?

30:13Gabrielle McGonagle:Yeah. So redemption rights are basically an investor right that after a certain period of time, the investor has the right to have the company repurchase its investment. You typically see these more with funds, private equity funds. And the reason for that is a lot of those funds have agreements with their own limited partners that they need to make a return on investment within a certain period of time. So typically what you would see is something like if by the fifth anniversary of our investment, the company has not sold, the company will have to repurchase or the investor can elect to have the company repurchase our equity at either fair market value or the investment amount, whichever is greater.

30:55Gabrielle McGonagle:Again, depending on when a company is coming in, what the valuation is, what that purchase price looks like, sometimes that's the cost of doing business with some of these funds, again, because they have their own internal structures where it's just a requirement. But there are some things that you can do to sort of soften that blow. And what I mean by that is one of the biggest issues is should that time come? If the company's doing really well and about to have an exit or has a lot of cash on hand, chances are that investor isn't going to want to be redeemed, right? They're going to want to stay until there actually is an exit.

31:29Gabrielle McGonagle:If things are going well, then great. Why would they try to jump ship then? Often we're seen this in situations where the company is struggling. And so in particular, those are times that a company is not going to have the liquidity and the cash on hand to actually effectuate that repurchase. And so it's important if you are agreeing to something like that to try to have certain protections there. Like, for example, first of all, the fair market value is fair, that it's either agreed upon or if there's a dispute, it goes to some third party evaluator. That way you can make sure that you're not getting stuck with this price tag that doesn't really make sense.

32:03Gabrielle McGonagle:The other thing is you can sort of negotiate sometimes the payment terms of that. So rather than saying, okay, on the fifth anniversary, we have to write you a check for your full investment amount or worse, depending on what the value is, you can say this will be repaid. And of course, the promissory note that maybe is a two-year promissory note. It can be paid off in installments. And then if there is a sale before it's fully paid off, it might accelerate those payments, right? So there are a couple of ways to sort of soften the economic blow to the company, should the redemption be something that is sort of like a non-starter for that fund or for that investor?

32:39Guys, I feel like maybe we're in the wrong part of this CPG business. Gabby, Adam, we should start one of these later stage funds that has all this money and then we can require redemption, right? So yeah, if this doesn't work out, you must buy it all back from us. Thank you very much. And if it does work out, we get participating shares and you have to pay us 3x and we get the equity. And that's how the people who have money make all the money. All right. There we go.

33:06Gabrielle McGonagle:It's a great insurance policy. Yeah. I'll follow up with you guys on the formation docs for that. Perfect. Okay. So Gabby, oh, I also wanted to ask you about pro rata rights and like, when are people typically asking for those and like, why would you want or not want that as a brand? Yeah. So pro rata rights also called preemptive rates, are basically an investor's ability to continue to maintain its ownership interest. So if Adam writes a check into a company and he owns 5 % of the company, each financing after that, he might say like, well, let me keep writing checks so that I can at least stay at my 5%.

33:41Gabrielle McGonagle:I wanted to come in and own 5%. I want to keep owning that 5%. So typically, pro-rata rates or preemptive rates are just the ability to keep investing to maintain your amount. It doesn't mean that you can go over that amount. It just level sets you. So almost always, even when we're putting together sort of like a common round or operating agreement or corp documents, we like preemptive rights. We like prorata rights. In almost all instances, if the existing investors want to continue to put money in and believe in the company, that's great. Not only does it keep a tighter cap table, but it's a great story for other investors that you may want coming in to say like, hey, we have these investors from the beginning who like really believe in this, are really happy with what we've been doing, and they want to keep investing.

34:22Gabrielle McGonagle:So preemptive rights are almost always great. Any investor is going to ask for them because they want to make sure that they're maintaining that. The sort of watch out for those is you want to make sure that if you have like a really unique opportunity, like a strategic coming in and saying, hey, I know that you're not doing a fundraise, but we want to come write a check and we want to be a part of this and we want to own 20 % of the company. you want to be in a position where you can take on that strategic and you can take on that investment without having to issue additional equity to other investors and open up a financing where you really don't need that cash, but you really instead just want that investor coming in.

35:03Gabrielle McGonagle:Similarly, there are certain service providers who will want equity in exchange for providing services. Again, that's not something like a financing round. So there are some customary carve outs that we try to negotiate with those preemptive rights and prorata rights to make sure that, yeah, you can maintain your percentage ownership unless it's one of these really special circumstances where the company needs to be able to issue equity even without going to everybody else and offering the same sort of situation. I think that's such a good example of one of those things that you could add into a longer document instead of a shorter agreement that like probably Probably no one's going to object to, but could really save your hiney when you're negotiating some sweetheart deal later on, like with a strategic.

35:48That's so good. Okay, so Adam, one thing I want to ask you about is about like reporting obligations. And just from personal experience as just a tiny little fish in this area, because I've mainly, I've only ever done like a safe type level investment. And I never thought to ask for reporting on any cadence. And mainly I'm a pretty small investor in those, so I don't think they would even do it if I asked. But some of them then were amazing and just gave me quarterly reports. And they were up into the right and they gave the breakdown and then included in there anything that they needed from investors.

36:26And it was amazing. And others. Honestly, there's one I pretty much never heard from again. Like, are you even working on this? Like, what's happening? I guess I don't have the right to ask for it. what should you expect after you take let's call it institutional capital on reporting yeah so i

36:42Adam Marsh:think before that right even to your point daniel say for convertible note like it's just really just good practice to keep your investors up to date with information it doesn't have to be formal documentation like we're going to talk about but the companies that succeed are the ones that are commutative with their investors even if it's a safe investor writing a ten thousand dollar check Everyone still wants to feel a part of the team. So I'd encourage everyone to always provide those updates. But once you get this institutional capital in, you're going to be expected to provide some regular financial information.

37:15Adam Marsh:There's these things called the NVCA documents, which all this stuff is based off of and kind of sets forth what you can expect there. So it'll be like monthly or quarterly financials, an annual budget, year-end financials. Once you get big enough, they're going to ask for audited year-end financials. cap table, and otherwise just like regular access to management. But that said, everything needs to be in balance, right? If you're a team of five, you can't be spending your entire day preparing these reports or else you're not going to be able to run the business. So it's really just about finding a balance between the size of the company, the level of detail that is really needed by these funds.

37:55Adam Marsh:Yeah, I think that's the key is finding the balance. And as the company grows, you can provide more frequent statements. But you can certainly expect monthly, quarterly, annual statements once you get a big tech writer in.

38:07Gabrielle McGonagle:Yeah. And Daniel, one thing you noted when you said sometimes it's really nice, you didn't even ask for you were getting all this information. I find even with a company that's struggling, I know sometimes there's an apprehension to tell investors bad news. That said, if there's a situation where things haven't been going well and the company has been keeping the investors in the loop, then if there's something where they're like, hey, we have to do a down round, it's not what we anticipated, but this is what we're gonna try to go out and do. We know there's certain anti-dilution rights, but we'd like you guys to waive those.

38:41Gabrielle McGonagle:If you have an investor group who's really been kept in the loop and who feels like they've been on the journey with you, they're a lot more likely to work with you in those situations rather than a situation where you're coming to them out of the blue. They haven't heard from you in a year and you're saying, hey, by the way, things aren't going well. So do you mind doing this? And so I think there's also this balance of like, what are my obligations, which you obviously want to limit versus what am I going to share with my investors in good faith anyway? because it just creates for a much happier shareholder base, even when things don't go well.

39:17Gabrielle McGonagle:An informed group is always a little bit more flexible and a little bit more apt to want to work together than when you sort of spring it on them. I totally agree. And it's a hard thing to do. And the same is true when you're talking to buyers or anyone of just like finding the right time to like, yes, this is time to give people a heads up about this and it will increase the trust in this relationship overall. I think investors know it's not going to go perfect 100 % of the time. If it did, they would be the richest investors in the world.

39:45Adam Marsh:Now, to your point, Jan, I was right, though. Building that trust amongst your board, amongst your investors, that's so important and so valuable. And it'll make things go so much more smoothly when things start going sideways. So yeah, I think that's a really good point, Amit. Honestly, that's what I really want to hear from people. Look, I don't have experience running a board or anything, but I do have experience being part of a team and running a team. And I think a former boss of mine, that was one of the most valuable lessons he taught me is like, I will trust you more if you come to me when there is a problem.

40:19Like if you raise your hand and ask me for help, then I will trust that you actually will tell me when there's something that I really need to be involved in. And that's a great thing to do. And like, I love that too. If someone on my team actually has a problem, they can't get around. Like, please tell me, yeah, that's exactly what I'm here for. Let me figure out how I can help you with that. And investors do have a lot of connections and ideas, and that's a great time to engage them. So Adam and Gabby, as we wrap up here, I would just love to ask generally about like when you're trying to negotiate things, what do you feel like of all these things that we've talked about are like when you're playing Jenga, some of the tiles are a little bit easier to push than others.

40:55Where do you feel like are the easier terms to negotiate and what are the ones that are harder to negotiate? Adam, I'll start with you. Yeah.

41:03Adam Marsh:So like the easy things are kind of the things we've talked about more recently, like preemptive rights, anti-dilution protection, information rights, confidentiality provisions. Like, let's not get hung up on those things. Those are notice prevailing. Like, it can seem onerous, but I don't really think I would worry so much about that. Focus on the big ticket items, right? The blocking rights, the valuation, the board controls, the things that we talked about at the beginning of this conversation. Those are the things that are really going to impact the company on a go forward basis. Whether the no shop period is 30 days or 45 days, probably less material unless you have 10 term sheets in hand.

41:45Adam Marsh:But limiting those blocking rights, as Gabby suggested, or making sure that liquidation preference is a 1x, I think that's going to ultimately have a much larger impact on the company than the preemptive rights section, the tag along sale, those sorts of items. I love it. That's very, very helpful to know. And Gabby, same question to you. And I'm sure because you've been doing this so long, like you've lived it. You've seen that point where you helped somebody actually get a certain provision negotiated and then seen how that actually impacted them later on. So, yeah, what would you say on this point?

42:17Gabrielle McGonagle:Yeah, I mean, echoing what Adam said, obviously, the protective provisions, I think, are the areas that anything that's going to limit a founder's ability to really run the day to day business, like these founders are gunslingers, they're entrepreneurs, it's necessary to move quickly in these sort of early stage companies. So limiting anything that's really going to handcuff you in that way. But I think also what I would urge in addition to try to limiting those protective provisions, like what I touched on earlier, to the extent you can move those to a preferred director block, as opposed to an investor block, it really will not only reduce the non-fiduciary control, but also lessen the anxiety, I think, around the brand owner, the founder having to face them.

43:04Gabrielle McGonagle:issue because they know that it's ultimately held in a best for the company position rather than potentially having an investor who can just hold it up for themselves. It's such a good point. And I've heard such crazy things also in this industry and world of like, yeah, that one person's a director. Like we want to sell the company and like we don't have any other options. Ultimately, it's not a great outcome for that investor who's on the board. And they're going to block it actually because they're raising another fund and they don't want to take the loss right now and have to tell all the people they're raising from about it like which is specifically not what they're supposed to be doing on the board but like oh god it's such a complicated world out there so i love the idea of just yeah really focusing on limiting the control stuff that people have so i think you guys made all the right points here i'm so excited for all of the brands coming in especially the founders and funders to have all of this ahead of time so they're not just scrambling when they hopefully get that term sheet from the funders who are coming to the event.

44:02So Adam, Gabby, thank you for another instant classic episode. This is so good. You guys are so generous with your time and expertise, having done this for collectively so many decades with everyone at the team over there. So thank you. And again, I really encourage anybody who has more questions about this to reach out to Adam and Gabby. They will be very happy to chat with you. Very accessible. So thank you guys again. This was just so interesting.

44:29Gabrielle McGonagle:Thanks for having us.

44:30Adam Marsh:Yeah, what a blast. Thanks, Daniel. And for people who are founders and funders, Gabby and I will be there. So don't hesitate to say hi. Yeah, thanks to Startup CPG. You guys rock. Thank you, guys. We really appreciate your support. Well, my friends, we've now arrived together at the end of another episode of the Startup CPG podcast, the top globally ranked podcast in CPG. As you may know, we're not just a podcast. We're a community of brands and experts, and you should join. You can sign up at startupcpg.com. You'll then get an invite to our online Slack community. You're going to hear about amazing events near you, all of our special opportunities to get you in front of buyers, investors, brands, and more.

45:10It's a free community. So what are you waiting for? I will see you there or on our next episode. Bye-bye.

45:28Thank you.