edocs, Inc. – Case questions
3. The most important terms for edocs founder Kevin Laracey to further discuss in future negotiations will be the following: • The valuation proposed by the Venture Capital investors, a number that could easily be inflated by shopping the deal around as the venture capital market is booming. • The Board of Directors provision, as Mr. Laracey wants to make sure that in the first years of the Company he will remain CEO, and that the co-founders of edocs will be part of it as well. • The share vesting schedule, which Mr. Laracey feels represents a lack of faith by the Venture Capital Investors in them. • The Anti-dilution and Right of First Refusal which in essence binds edocs to future and larger equity participations from CRV. • The warrants issue subject to the availability of other VC investors. This clause is troublemsome for the CEO of edocs because it will cause further dilution of his his colleagues stakes in the Company.
4. As for Charles River Ventures, Mr. Guerster has essentially two main things in mind regarding the term sheet: • The board composition, because he feels that Mr. Canekeratne is not suitable to be a board member as he will bring no added value to the company, and a large board of directors is not feasible. • The warrants issue that Mr. Guerster feels is an appropriate penalty for edocs if they cannot find other investors to do the deal with.
5. edocs is searching for venture capital financing in 1998, a vibrant year for the market. Furthermore, the term sheet that was presented to them was quite investor friendly, with some strict provisions that unnecessarily burden the entrepreneurs. In short, edocs can and should negotiate some of the terms presented to them by CRV. First of all edocs is aware that if it shopped the deal around it could get a higher valuation and the provision to include the employee share option pool in the valuation seems too onerous. An acceptable compromise between committing to CRV and to dilute their stake so much in the beginning would be to exclude the option pool from the valuation. This would change the VC’s stake from 38% to 33%. May not seem like a respectable sum at first, but it may be relevant to encourage future financiers. The lower the A round investor’s stake, the better. Another provision that should be altered is the board composition. As it was mentioned before, this is bound to be one of the most contentious issues between the entrepreneur and the VC. The founders argue that all 3 of them should be on the steering wheel after the investment, while CRV insists on having a small board of directors with as many board representatives as the founders (2 and 2). It is likely that the founders will have to cave in on this issue because it’s not likely that they would get better terms elsewhere. Even if it is unreasonable to put the 3 founders of the company on the board, as the VC will not want it to have a founder majority, at least Mr. Laracey should be granted a place as a CEO for a fixed amount of time. In a very early stage it is important for the Company to have the guidance of someone who founded and knows the business by heart. Perhaps more importantly we have the warrants provision. There is a rational economic reasoning behind this provision. If CRV cannot find another party to invest in the Company this will mean two things: investors are not willing to bet on the success of edocs which sends a negative signal to CRV, and it will result in an undiversification of its portfolio and consquently more risk. CRV will consequently want a compensation for this extra risk and the warrants are apparently the answer. We have to take edocs’ position into account though. As we will see later they have negogiating leverage and as such are in a position to change the provision. On the other hand, the clause at the least creates some perverse incentives for CRV. If CRV is or turns out to be confident about the future...
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