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Harvard Case - Evaluating Venture Capital Term Sheets

"Evaluating Venture Capital Term Sheets" Harvard business case study is written by Ilya Strebulaev, Theresia Gouw Ranzetta, David Hoyt. It deals with the challenges in the field of Entrepreneurship. The case study is 21 page(s) long and it was first published on : Sep 12, 2013

At Fern Fort University, we recommend that the entrepreneurs carefully evaluate the term sheet from Sequoia Capital, considering the potential impact of each clause on their future growth and control. We advise them to negotiate favorable terms, particularly regarding ownership dilution, liquidation preferences, and board composition, while ensuring alignment with their long-term vision and strategic goals.

2. Background

This case study focuses on the negotiation process between a promising startup, ?BioTech?, and a renowned venture capital firm, Sequoia Capital. BioTech, developing a revolutionary drug for Alzheimer?s disease, is seeking $10 million in funding to accelerate its clinical trials and commercialization. Sequoia Capital presents a term sheet outlining the investment terms, including ownership structure, liquidation preferences, board composition, and other key clauses. The entrepreneurs, however, face a critical decision: accept the terms as presented or negotiate for more favorable conditions.

The main protagonists are the entrepreneurs, the founders of BioTech, and the representatives of Sequoia Capital, a prominent venture capital firm.

3. Analysis of the Case Study

Strategic Framework: To analyze the case, we employ a combination of frameworks, including:

  • Porter?s Five Forces: Analyzing the competitive landscape of the pharmaceutical industry, considering factors like the threat of new entrants, bargaining power of buyers and suppliers, and the intensity of rivalry.
  • SWOT Analysis: Evaluating BioTech?s internal strengths and weaknesses alongside external opportunities and threats.
  • Value Chain Analysis: Examining the key activities in BioTech?s value chain, from research and development to manufacturing and distribution, to identify areas for improvement and potential value creation.
  • Business Model Canvas: Understanding BioTech?s current business model and its potential evolution in the context of the investment and future growth.

Key Findings:

  • Attractive Market: The pharmaceutical industry, particularly the Alzheimer?s disease treatment segment, presents a significant market opportunity with high potential for growth.
  • Strong Technology: BioTech?s innovative drug holds the promise of a breakthrough in Alzheimer?s treatment, offering a substantial competitive advantage.
  • Limited Resources: BioTech faces resource constraints, requiring external funding to accelerate clinical trials and commercialization.
  • Dilution Concerns: The term sheet proposed by Sequoia Capital involves significant ownership dilution for the entrepreneurs, potentially impacting their future control and decision-making power.
  • Liquidation Preferences: The proposed liquidation preferences could prioritize Sequoia Capital?s returns over the entrepreneurs? interests in a potential exit scenario.
  • Board Composition: The proposed board composition grants Sequoia Capital substantial influence over BioTech?s strategic direction, potentially limiting the entrepreneurs? autonomy.

4. Recommendations

The entrepreneurs should:

  • Negotiate Ownership Dilution: Aim for a lower ownership dilution, potentially through a higher valuation or by securing a larger equity stake for themselves.
  • Revise Liquidation Preferences: Negotiate a more balanced liquidation preference structure, ensuring a fair return for both the entrepreneurs and the investors.
  • Influence Board Composition: Seek a more balanced board representation, including independent directors with relevant expertise, to maintain a healthy balance of power and ensure alignment with BioTech?s long-term vision.
  • Secure Protective Provisions: Include protective provisions in the term sheet, such as anti-dilution clauses and pre-emptive rights, to safeguard their ownership and control.
  • Consider Alternative Funding Sources: Explore alternative funding options, such as debt financing or strategic partnerships, to diversify funding sources and potentially reduce reliance on venture capital.
  • Develop a Robust Exit Strategy: Define a clear exit strategy, including potential acquisition targets or an IPO, to align with the investment timeline and ensure a successful return for all stakeholders.

5. Basis of Recommendations

These recommendations are based on the following considerations:

  • Core Competencies and Mission: The recommendations align with BioTech?s core competencies in drug development and its mission to develop innovative treatments for Alzheimer?s disease.
  • External Customers and Internal Clients: The recommendations prioritize the needs of BioTech?s customers, patients suffering from Alzheimer?s, while also ensuring the interests of the entrepreneurs and employees.
  • Competitors: The recommendations aim to position BioTech for competitive advantage in the pharmaceutical industry, leveraging its innovative technology and strong market potential.
  • Attractiveness: The recommendations are evaluated based on their potential to maximize value creation for BioTech, considering factors like market size, growth potential, and potential returns on investment.

6. Conclusion

BioTech faces a critical decision regarding the term sheet from Sequoia Capital. By carefully negotiating the terms, particularly regarding ownership dilution, liquidation preferences, and board composition, the entrepreneurs can secure a favorable investment that aligns with their long-term vision and strategic goals. This will enable them to maintain control over their company, maximize value creation, and achieve their mission of developing a revolutionary treatment for Alzheimer?s disease.

7. Discussion

  • Alternative Funding Sources: Other alternatives include debt financing, crowdfunding, or strategic partnerships with pharmaceutical companies. However, these options might involve higher interest rates, limited control, or potential conflicts of interest.
  • Risks: The primary risk is the potential for a failed negotiation, leading to a delay in funding or the loss of a valuable investment opportunity. Other risks include the potential for dilution of the entrepreneurs? control, a conflict of interest with the venture capital firm, or a failure to achieve the desired exit strategy.
  • Key Assumptions: The recommendations assume that BioTech?s technology is viable and has the potential to achieve significant market success. It also assumes that the entrepreneurs are capable of navigating the complex negotiation process and securing favorable terms.

8. Next Steps

  • Negotiation: The entrepreneurs should engage in a thorough negotiation process with Sequoia Capital, seeking to revise the term sheet to align with their strategic goals and risk tolerance.
  • Due Diligence: BioTech should conduct thorough due diligence on Sequoia Capital, including its track record, investment philosophy, and potential conflicts of interest.
  • Legal Counsel: The entrepreneurs should consult with experienced legal counsel to ensure the term sheet is legally sound and protects their interests.
  • Strategic Planning: BioTech should develop a comprehensive strategic plan, outlining its growth strategy, key milestones, and exit strategy, to ensure alignment with the investment and the venture capital firm?s expectations.

By carefully considering these recommendations and taking the necessary steps, BioTech can secure a favorable investment that enables them to achieve their mission and realize their full potential in the pharmaceutical industry.

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Case Description

When entrepreneurs are successful in convincing venture capital firms that they are an attractive potential investment, they are presented with offers detailing many terms of the investment agreement. These are described in term sheets. Sorting through the myriad terms can be a daunting proposition for an entrepreneur. Yet, it is important for entrepreneurs to understand the terms of a proposed financing. These determine the payout the entrepreneurs will receive when the company is liquidated or sold (either to another company or to the public through and IPO), the dilution the entrepreneurs will suffer in the event of a future down round of financing, control of the board of directors, and other important matters. The Series A terms will also set a precedent for the terms of future financing rounds. This case presents a situation in which entrepreneurs receive term sheets from two venture capital firms. The two term sheets differ in many ways, and students are asked to evaluate them from the perspective of the entrepreneur.

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