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IPO and Venture Capitals Case 2

1. Describe the different terms of the contract:



Inspection rights (at reasonable times, on reasonable notice)
Positive Sum
Provides a double check for founders accounting methods
Allows investors to spot any illegal accounting methods

Seats on the Board
Positive Sum
The seats are relatively split between all the parties making no one group the
clear winner
Original shareholders worked better as a team and not with one as the leader,
the tentative CEO, this may reduce synergy within the group

VC approval (75% vote) for capital expenditures, new share issues, asset sales, etc.
Negative Sum
The categories that require approval are reasonable but regardless of what
needs to be done the high approval rate, 75% of Series A, requires that any
changes have to be approved by the investor group giving them the power in
future negotiations, even if the other 55% of Series A holders want the change
This power requiring all changes to go through the group might slow down
company development since all changes require their approval first
Might be beneficial for all parties to lower the approval rate below the current
75%

Piggyback registration
Positive Sum
Allows the investors to cash out at the IPO
Allows the founders to purchase back some shares of their company

Pre-money valuation (in other words, the proportion of shares that will go to the VCs in
exchange for the money they are putting up)
Negative Sum
Founders originally planned on only allocating 35% of equity to VCs
Significantly less say in the company at 45% to investors
Forces the founders to rearrange their equity allocations if accepted

Control (2 of 3 seats) of the Auditing Committee
Positive Sum
Since investors have majority control this would help keep the founders honest
during evaluations of the business
Investors might be able to take advantage of control by keeping founders in
the dark during audits if the founders fail to put in their due diligence

Control (2 of 3 seats) of the Compensation Committee
Negative Sum
Since the investors have majority control on this committee they can favor
compensation to their own party, resulting in underpaying the founders
If the founders begin to feel underpaid they might be demotivated to perform
in the company's best interest

Pre-emptive rights
Positive Sum
Investors can refuse to allow the issuance of common stocks to maintain their
control over the company, but generally would want to gain more investors so
they can increase their return during the eventual cash out
This allows the investors to preemptively avoid dilution in the future

2. Which items should be renegotiated:

The items that should be renegotiated are the negative sum aspects of the terms since
those have a clear loser and would probably be detrimental to the business relationship
moving forward. The only exception is the Pre-Money valuation of the shares distributed
since the figures the original founders plan on distributing were internally discussed and not
made public information. They can still decide to negotiate based on those figures though.

The terms that should be renegotiated:
VC approval of capital expenditures, new share issues, asset sales, etc.
Control of the Compensation Committee

If these terms were renegotiated in favour of the founders it might be able to procure
more investments in future rounds since the investor group has less control and other
investors might be more willing to fund in the future. I believe the investor group expected
their terms sheet to be a take it or leave it option but in business everything is negotiable and
if the founders were to just sign away their company without an attempt to negotiate, the
investors might take that as a sign of a lack of faith and cause some tension in the
relationship.

3. Reallocation of remaining equity:

The first possible scenario for reallocating equity would be to change the amount of
shares the owners receive. They either can change the amount of shares equally or they can
reduce one persons shares more than the others. This decision easily could ruin a partnership
especially with the CEO decision looming over their heads. There also is the possibility of
just reducing Wangs stake in the company because he was not an original founder. This is a
dangerous route to choose especially since all three have put so much time and effort into
Return Logic Inc.

Next was the possibility of reducing the amount of equity angel investors or the option
pool received. There is a considerable amount of risk with making this decision as well. The
3 angel investors invested large amounts of money to the company before anyone else had
interest. This shows that they had great faith and loyalty to the company. Not to mention their
expertise, knowledge, and connections in the industry could help the company grow even
more. Then if they were to reduce the option pool, they would be taking away the benefits of
the employees who work so hard for them. This could potentially limit the growth of the
company especially when attempting to hire new employees or hiring new ones.

This is a difficult situation to be put in especially since so much time and effort had been
put forth up until this point. A certain amount of commitment had been put forth by each of
the parties and now the amount of equity they receive is being reduced. The opportunity put
forth by Insight is too good to pass up, but I think there can be some flexibility here. They
should attempt to negotiate the 45% to see if they can reduce that number, even if it is only a
minimal amount. Next, if the owners did have to reduce equity of another parties, then I
believe they should divide up the losses equally, but not reduce the amount of the angel
investors. Since it had been such a team effort up until this point, to cut someones shares
more than the others would not be right. This demonstration of good management would
show great leadership and commitment to one another. The investors experience and
knowledge is way too valuable and they should avoid the possibilities making them upset and
losing them. The founders of Return Logic should have been prepared for a situation like this.
They may have over valued some of the parties involved in the beginning and it is difficult to
go back on their word.

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