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Every term sheet is structured differently, but “securities” is typically the first thing you will see. This is a very simple, one-line term stating the type of stock investors are purchasing and the round of financing. It will look something like this: “Shares of Series Seed Preferred Stock of the Company.”
You can also expect to see this term at the top of your term sheet. How much is the investment?
If this is your lead investor term sheet in a priced round, there will be bullets covering the following:
How much the lead investor is putting in.
How much others are putting in.
This amount adds up to the total round size. The lead investor will say, “We’re putting in $1.5M, and we’re expecting $1.5M in aggregate from other investors.”
If you’re raising on a convertible, this section will include any stock that’s converting from safes or notes as part of the round, and it could have allowances for each of those.
Price per Share and Valuation
This term will include the price per share the investor will be paying, and the valuation the price is based on. We discussed the interplay between price, valuation, and dilution of ownership in Determining How Much to Raise.
important You may receive a term sheet with price per share blank. You and the investors are negotiating a valuation, and once that amount has been agreed upon, your lawyer will do the math to determine the price per share.
danger It’s common for VCs to just say “valuation” in an offer without specifying whether they mean pre-money or post-money valuation. For example, “I’ll write you a check for $5M at a $20M valuation.” But there is a big difference between a $20M pre-money valuation and a $20M post-money valuation. As a founder, it’s critical to be aware whether you’re discussing pre-money or post-money valuation, so speak up and make sure both sides are clear.
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Practically, when negotiating this term you need to communicate with your investors about the following:
Percentage of the company you’re selling (20%).
Amount that you’re raising (when you’re backing into a valuation, you’re thinking of selling 20% for $10M, because you need $10M to reach a set of milestones before you raise again. The investor may say that they want to give you $10M for 25%. If you have no other deals or you really want to work with this investor, you say OK.
Whether the valuation is pre-money or post-money.
If you’re raising on a convertible, you will have a separate term for the valuation cap and should discuss whether it is on a pre-money or post-money valuation.
Depending on how much you communicated with investors in earlier investor meetings, you might go into term sheet negotiations knowing what valuation to expect, or you might go in ready for a serious conversation.
important Most founders aren’t going to be choosing between different valuations on multiple term sheets from top-tier firms. If you are, congratulations. But most of you will be choosing between one term sheet and shutting your company down, or between one term sheet from a great fund and a term sheet from a mediocre fund. Aim for the right valuation, not the highest. High valuations give more space to fall short, which has consequences for future fundraising and can lead your investors to look for an exit strategy that is not in your best interest. You may even consider compromising on valuation for a higher caliber VC firm; or, in the same vein, offering a premium investor a lower price (more equity for less money). Keep in mind a minimum valuation and a lower price you’ll accept without further negotiation, but don’t share those numbers.
You may see “liquidation preference” as a term in your term sheet, “liquidation rights,” or simply “liquidation.” This is a big one.
Liquidation preference means that preferred shareholders get paid before anyone else. You’ll often see preference expressed as “a 1X liquidation preference,” where the 1X refers to the multiple—that is, a return of the original investment amount. We discuss preference in detail in Choosing a Financing Structure.
Practically, founders will need to be able to explain liquidation preference when speaking with new investors inquiring as to how much money has been raised to date. Additionally, most seasoned executives will ask about liquidation preference when joining to get an idea of how much the company would have to sell for in order for them to make any money off any stock you offer them.
In the term sheet, you will see a line that says something like, “The proceeds shall be paid as follows.” That’s called the liquidation preference stack, after which the remainder of the proceeds from a liquidity event will be distributed to holders of common stock.
Definition The liquidation preference stack (preference stack or seniority structure) is the order in which a company’s preferred stockholders are paid out in a liquidity event where automatic conversion does not apply. The liquidation preference stack is sometimes referred to as a seniority structure because investors higher up in the payout order are considered to have preference that is senior to those lower in the stack.
In general, preferred stock will be pari passu or “on par with each other,” so everything from Series Seed to Series F stockholders—and all investors in between—get paid out at the exact same time. If there isn’t enough money to pay out all investors, then the funds are distributed to investors according to their ownership percentages. In some cases, the payout may be “last money in, first out,” meaning the most recent investors are able to recoup their money first.* Even in the case of pari passu stock, investors decide whether to exercise their preference or participate via common stock, starting with the most recent investor first, provided that their preferred stock is not automatically converted into common stock. For more on liquidation preference stacks, we recommend Caleb Kaiser’s “Liquidation Preference: Your Equity Could Be Worth Millions—Or Nothing.”
Conversion rights have important downstream consequences. They are complicated and can be confusing—we cover this term in Choosing a Financing Structure.
danger Having multiple automatic conversion thresholds can give the investor with a higher threshold leverage to block an IPO.*
caution While most protective provisions are not negotiable, many founders do not realize the control dynamics these provisions create. In most significant priced rounds following the seed, the company will have to agree to protective provisions. Too often, founders inaccurately believe ownership percentage is the ultimate driver of control dynamics. But protective provisions, while they shouldn’t be considered backdoor mechanisms for investors to sneakily exert control, can absolutely compel you to compromise on big decisions for your company. It is critical for you to know what decisions you will have to consult your investors on after agreeing to protective provisions.
important You’re likely to spend a lot of time here with your lawyer. Despite appearing as a single term, the protective provisions section of your term sheet will typically outline up to 12 decisions investors can veto.
Here are some of the situations commonly covered by protective provisions:
Changing the certificate of incorporation or bylaws of the company. This term is usually not negotiable. Good counsel will push to alter this provision to allow the preferred stock to vote on any change that “adversely affects the rights” of preferred stockholders, but not any change to the certificate of incorporation or bylaws. Anyone seriously considering converting their company to a B corporation should take note that, after this provision is in place, their investors can veto this conversion.
Changing the authorized number of shares of preferred or common stock. Any change in the number of either type of share would affect the value of investors’ stock, so it’s no surprise they’d want a say in this.
Issuing stock senior or equal to the new class of preferred. This provision is relevant when a company wants to acquire another company and use stock in the transaction. The target of the deal will often end up with common stock, but each acquisition is a negotiation. In some cases, the entire preference stack is modified. In any case, the VCs will want a say in how the deal gets structured.The vote here would be on creating a new class of preferred stock that is junior to the investors but senior to common stock.
Buying back any common stock. This provision governs when the company can buy shares back from employees or other shareholders. Founders should fight for some carve-outs here—that is, contingencies where the provision would not apply: repurchase rights, rights of first refusal, and certain other decisions the board would want to approve. In the case of repurchase, you’ll want to buy back any unvested stock in the event that an employee or founder leaves. Finally, you want to specify, in writing, a carve-out for the board to approve any one-off repurchase as part of a settlement in the case of a separation agreement.
Selling the company. Preferred stockholders will definitely want to have a say when it comes to selling your company. This also applies to mergers.
Borrowing, loaning, or guaranteeing any money. Investors will definitely want a say in decisions related to bringing on significant debt, or lending out money.
Changing the number of directors on the board. Changing the number of directors on the board can effectively change who controls the company, making this term non-negotiable.
Declaring or paying any dividend. While dividends are usually a separate term, a protective provision almost always exists to govern whether a company can declare a dividend or not.
Creating or issuing any kind of cryptocurrency or token. As of 2018, this protective provision is standard in most term sheets.
Declaring bankruptcy. In the unfortunate circumstance that you’re considering declaring bankruptcy, investors will want to know and have a say in how the company liquidates.
Licensing away the IP of the company. On one hand, this provision is there to protect naive entrepreneurs from structuring licensing agreements in a manner which can dramatically hurt the company. On the other hand, the protection is for investors in the case that an entrepreneur tries to set up a separate company, which they own all of, and then license the IP of the company the investors own part of to the new company that the entrepreneur owns all of (yes, people have done this).
Option pools are usually agreed upon and allocated before a financing takes place. Companies usually create an option pool before the first employees are hired, but option pools also get refreshed, or new option pools get created, before subsequent financings. This is important, because if the pool is allocated after an investment, then the new investor(s) will be diluted with the founders and prior investors.
important Investors will almost always negotiate for the pool to be allocated before the investment takes place. Founders should make sure to understand how the option pool will impact their ownership* (visit our primer on ownership for more details). Founders should also be sure investors aren’t using the option pool to manipulate the optics of the deal.*
Option pools are part of the pricing dynamic in a negotiation, and founders should be clear whether they are required to create or refresh an option pool prior to or after the round of financing they’re raising.
important You must communicate with your investor about whether the option pool is being calculated pre-money or post-money. Investors often require companies to “refresh” or “true up” the option pool to some target allocation (depending on the deal, often 10–15%) of a company’s fully diluted capitalization, but factored into the pre-money valuation or prior to an investment. If this isn’t taken into account when expressing the pre-money valuation, a founder may think they’re getting a better deal than they are.
When negotiating the size of an option pool, it can be tempting to pick a round number like 10%, 15%, or 20%. Investors will almost always encourage you to pick a higher number, as it reduces the chances they’ll get diluted soon. Instead of picking a round number, founders should budget out the hires they anticipate making over the next 12–24 months (you can usually get away with a 12-month plan at the early stages, but later-stage investors will want 24) and create an anticipated budget for the equity you’ll need to give those employees. Use that bottom-up number to benchmark how large your option pool should be. A typical size for the option pool is 10% at the earlier stages and 20% at the later stages.
Aspects of your company’s vesting policies may be negotiated in your term sheet. Depending on what the investors are hoping to affect, this term may appear as “founder vesting,” “founder and employee vesting,” or simply, “vesting.”
dangerWhen getting started, many founding teams delay legally outlining the terms of their vesting. Often this is because the founding team trusts each other and believes it is safe to figure out the terms of their ownership later. This is always a mistake. Founders also get into trouble when they decide not to use a vesting schedule but instead give each founder a share of the company that is fully vested on day one. This practice is the cause of endless headaches and can ruin long-held relationships. Consider the following scenario. Three founders start a company, they’ve been friends since high school, they trust each other, and everyone says they’re committed for the next ten years. As a result, they agree not to utilize a vesting schedule. Two years later, two founders agree to fire the third founder for inappropriate behavior. Since they didn’t utilize a vesting schedule, the third founder will continue to hold their full share of the company; had they used a standard vesting schedule, they would hold half as much. This failure to utilize vesting is why investors usually require founders to all be on a vesting schedule, just like employees.
DefinitionAccelerated vesting (or acceleration) is vesting that occurs outside the vesting schedule and is triggered by contractually specified events. Single trigger requires only one event, such as the sale of the company, for accelerated vesting to occur. Double trigger requires two events, generally the sale of the company plus the person involuntarily leaving the company without being fired for cause.*
caution Investors sometimes try to negotiate down the percentage of stock that gets accelerated. According to Fenwick & West, 100% double-trigger acceleration is standard for founders, but many venture firms think 50% or one year of acceleration is standard. Founders should push for 100%. It isn’t a transfer of wealth from investors to founders, because the acceleration is only triggered if the founders are terminated in connection with a change of control of the business.
When raising a priced round, almost every venture capital firm will require founders to reset the vesting clock on their stock at the time that the deal closes, especially when founders have already vested more than 25% of their stock. For example, if you’ve been working on your company for two years on a standard four-year vesting schedule with a one-year cliff, you will have one half of your stock vested. Revesting requires the founder to restart their vesting. This can be a touchy negotiating item for founders who have spent two to three years working on something. Naturally, they feel entitled to vested ownership in the company they’ve been working on for so long. Investors’ motives here are not sinister. They are betting on the founders and want to see founders show they are committed to the company for the long-haul. Take this as a compliment: they want to make sure you continue to run your business.
If founders have been working on the company for a significant period of time prior to fundraising but are only just now incorporating, it is not uncommon for term sheets to include a small vesting balance to compensate the founders for their work. If the founders have been working on the company for two years but are only now incorporating, instead of starting their vesting on the date of incorporation, a vesting balance would vest some stock for the founders to recognize the time they worked prior to incorporation.
Investors may negotiate a board seat on the company’s board of directors.
When a startup forms a board of directors, the primary role of the board is to make key strategic and operational decisions for the company. The board typically holds regular three- to four-hour board meetings. These are often held quarterly or every six weeks; when a company is young they could be held monthly. In these meetings, the board discusses progress, goals, challenges, key hires, and all sorts of operational issues. A board meeting is used to align the operations with the interests of the investors and founders. While board meetings are often viewed as a tool for investor oversight, they are very much also about founders seeking the board’s counsel and advice.
Definition A board observer is an individual who participates in a company’s board meetings as though they were a board member, except that they are not permitted a formal vote and do not have the same level of responsibility to the company as full board members.*Venture capital funds like to ask for board observer seats in order to weigh in on matters of importance to them and show more inexperienced investors the ropes of how board meetings work. Some investors will negotiate for a board observer seat in addition to a full board seat, while others may negotiate only for one of these.** Although they are non-voting, board observers can have considerable influence on startups because they are present during board discussions.*
caution Granting board observer seats can be a dangerous and slippery slope. Board observer seats can be used as an indirect control mechanism. Though they are non-voting, board observers sit through the entire board meeting, participate in discussion, and have access to all board materials. Board observers change the dynamic of a board meeting by weighing in with thoughts and opinions. If your board is only three people and you grant a board observer seat to one of your investors, 50% of the room will now represent your investors’ firm and their interests. Finally, once you grant one firm a board observer seat, future investors will not only ask for observer seats as well, but many will insist you grant them one. All board observers are legally obligated to behave in accordance with confidentiality agreements, but they may be more likely than more senior investors to share board materials with outside parties in violation of these agreements. If a board observer behaves badly, they should not be allowed back, but you may not always know when something has been leaked.
It’s important to realize that boards of directors increase in size over a company’s life. When you’re first incorporating, your board can range from one to three people, but you want to keep it small. It may seem fair to have all three (or more) co-founders on the board, but it can be hard to ask your co-founder to step off the board later. Many startup boards can be as small as three people all the way through a Series A (two co-founders, or one co-founder and an outside board member, and a Series A investor). Boards of directors in general, including public boards, range from 3 to 31 members, with an average size of 9.* Boards are almost always an odd number in order to avoid tie votes. It’s worth noting that the state of California requires public companies to have at least one woman* on their boards.
important While not all pre-seed or seed-stage investors will take a board seat, many early-stage founders find it helpful to create a board of directors or hold board meetings and have one of their largest investors attend regularly. Without regular board meetings, it’s easy for founding teams to fall prey to groupthink, shrugging off valid criticism. Holding regular board meetings also helps early-stage teams get in a regular rhythm of setting objectives, making decisions, and reflecting on outcomes, which can help prepare founders for leading the company as it grows into a team with executives and a formal board of directors.
Definition An information rights provision in a term sheet outlines the information a company must deliver to investors beyond what state law requires.* Generally, this includes a commitment to deliver regular financial statements and a budget to investors. A term sheet’s information rights typically terminates in the event of an IPO and often gives investors access to the company’s facilities and personnel.*
While the default reporting period is quarterly, investors may ask for financial statements on a monthly basis early in a company’s life. Many companies elect to provide monthly financials to major investors for a long time.
Founders have a wide range of opinions about transparency. Some founders won’t mind sending every investor their financial statements monthly, and others will be less comfortable sharing information with too many people. Sending your financial statements to each different investor when they request it can become burdensome, and founders should consider how comfortable they are with their financial statements being in the hands of a large number of investors. If you do grant information rights to investors below your major investor threshold, make sure you aren’t committing to providing two different sets of documents on two different schedules to different investors after you raise a further round of funding.
When offering any information rights at the seed stage, make it clear to each group that they will have the same information rights and schedules as your Series A investors. Keep in mind that there may be a major investor threshold in a subsequent round that is higher than a previous investor’s ownership percentage, and you’ll likely need to continue to agree to information rights for those who have held them before.
important Note that information rights may be reserved for major investors.
Legal Fees and Expenses
controversy In addition to paying their own lawyers for work done related to negotiating a term sheet, the vast majority of venture capital funds require the startups they invest in to pay for a portion of the investors’ legal bills. Investors’ legal fees, if not paid for by the startup, come out of investors’ management fees. A small group of venture capital firms, including K9 Ventures, Afore Capital, Bloomberg Beta, Homebrew, and Spark Capital, believe investors should pay their own legal expenses. Critics believe these firms are employing a marketing tactic akin to “founder-friendly religious activity,” saying that who pays legal expenses is a minor point in the scale of an investment deal, and over-negotiating on the bill is ultimately a waste of energy.
At the very least, founders can manage the legal fees by putting a cap on them. In early-stage deals, a cap of $10K–$25K should be acceptable. Caps on legal fees can be powerful when founders are negotiating with a syndicate, as it motivates the investors to coordinate the legal activity rather than throwing a gaggle of lawyers into the negotiation.
For most financings, the majority of the legal costs come from legal diligence and corporate records cleanup, not the back-and-forth between lawyers arguing over the terms of a term sheet or the stock purchase agreement in the long-form docs.
danger Even if you’ve negotiated a cap on the portion of your investors’ legal fees you’re responsible for covering, your counsel’s fees can get out of control if you aren’t careful. If your lawyers are arguing about anything meaningful, you should tell them to bring it to you before it goes back and forth between different legal teams more than once.
Alex McCaw, co-founder of Clearbit, offers an alternative strategy to keeping fundraising bills low in chapter 26 of The Great CEO Within, by Matt Mochary. McCaw proposes founders set up a four- to eight-hour meeting with the decision-makers and lawyers from both the company and the venture firm. In this meeting, lawyers are only allowed to speak when advising their client on the meaning of a specific term. Once terms are agreed to, lawyers agree on wording for each term in the meeting, and one side’s counsel draws the final documents up from there. After you’ve signed a term sheet, there shouldn’t be much left for lawyers to go back and forth on beyond wordsmithing, diligence, and corporate cleanup.
Pro Rata Rights
DefinitionPro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.
Pro rata is Latin for “in proportion.” Most people are familiar with the concept of “pro rating” from dealing with landlords: if you’re entering into a lease halfway through the month, your rent may be “pro rated,” where you pay an amount of the rent that is in proportion to your time actually occupying the property.
Almost all investors try to negotiate for pro rata rights, because if a company is doing well they want to own as much of it as possible. After all, why not double down on a winner than use that same money to invest in a newer, unproven company? In the 2018–2019 fundraising climate, though, it’s safe to say we’re at “peak pro rata.” Everybody wants pro rata, even those who don’t entirely understand how it works or affects companies.
Some founders include a major investor clause in the term sheet, which reserves certain rights and privileges to those they deem “major investors.” Whether to grant pro rata rights to all investors or only those above a major investor threshold is a tricky decision for two reasons.
First, when companies use a major investor threshold to determine who gets pro rata rights and who does not, angel investors usually don’t make the cut. Angels hate this because it limits their ability to gain more ownership in a company they see themselves as having spotted and supported early on. VCs want the threshold because they don’t want to share pro rata rights with a larger group of investors. This is a major source of conflict between angel investors and VCs.
Second, companies are often optimizing to only sell a certain amount of the company to investors—20% is a common number for a traditional Series A.* The decisions around whether existing investors take their pro rata or some part of it are often negotiated as part of each subsequent round of financing, as new investors can’t always meet their ownership targets when existing investors all take their pro rata without the company selling more than they’re comfortable with. This is always a struggle—either new investors have to cut back how much they’ll invest or existing investors will have to cut back and not take their full pro rata. Companies and investors usually recognize the new round can’t dilute the founders too much and work together to negotiate a satisfactory deal.
When determining who to give pro rata rights to, founders need to take into account the risk of a deal breaking down because new investors and existing investors with pro rata rights can’t come to an agreement that works for everyone. While this may be rare, it’s worth knowing how your investors think about a situation like this before you find yourself there.
Just because a VC has pro rata rights doesn’t mean they have to invest anything into your next round. Founders should assume they have to earn investors’ pro rata for each subsequent round. Whether an investor takes their pro rata also depends on whether they hold reserves for companies they invest in. When talking with an investor, it’s worth asking them how they think about pro rata and whether they hold reserves for each of their investments to take their pro rata.
Once you’ve given pro rata rights, they tend to survive into the future. This has two implications. First, you’ll have to negotiate with everyone you gave pro rata rights to in previous deals, and if you’re doing well, early investors with pro rata rights are incentivized to want to own more of your company (they’re also incentivized to get the deal done so you can keep growing, however).
Second, other investors will ask who has gotten pro rata rights. If you’ve held to a bright-line rule, you’ll hold the moral authority of saying, “We’ve only given investors below X amount pro rata rights, and we don’t intend to change that.” This strategy may sound nice on paper, but consider what you’ll do if your dream investor wants in on the deal with a small check, but only if you grant them pro rata rights.
Pro rata rights can be calculated on a percentage, dollar-for-dollar, or fixed-sum basis.
Percentage basis. This is the most common. In this scenario, investors have the right to maintain their ownership percentage by continuing to invest more capital in subsequent rounds. For example, if an investor owns 5% of a company when their safe converts to equity, they can invest more money to maintain their 5% ownership at subsequent rounds.
Dollar-for-dollar basis. Much less common, this type of pro rata gives investors the right to invest an equal amount or less than the amount they invested in the first round. For example, if an investor puts $250K into the company in their first round of financing, that investor can invest up to $250K in future financings.
Fixed-sum basis. Even less common, investors who get pro rata on a fixed-sum basis maintain the right to continue investing an amount as agreed upon that is decoupled from the investment amount. For example, if an investor who invested $1M in a seed negotiates pro rata rights up to $500K, they will be able to invest up to $500K in each subsequent round of financing.
caution Dollar-for-dollar and fixed-sum basis pro rata rights can result in “super pro rata” rights, which companies should always seek to avoid.
Definition A super pro rata rights provision in a term sheet or side letter grants investors the right to buy a larger percentage of a company in a subsequent financing round. Super pro rata rights may be expressed as a multiple of the investor’s original ownership stake,* or they may result from dollar-for-dollar or fixed-sum pro rata rights where the amount the investor will invest in a subsequent round gives them a larger ownership stake than they started with.
For example, if an investor owns 5% of a company after their first investment and has the right to purchase any more than 5% of the company in a subsequent round, they have super pro rata rights.
dangerSuper pro rata rights are dangerous to companies because of the dynamic they create with existing investors and new investors.
First, super pro rata rights create ownership conflicts. Many VC firms have a rough target ownership percentage of 20% (in a traditional Series A), and 20% can often be the amount a company is selling in a round of financing. If a company grants an existing investor a 15% super pro rata right on the next round, it will be hard to find another investor interested in only having 5% ownership.
Second, super pro rata rights can signal risk. If a company grants a VC firm super pro rata rights and they decide not to invest past their percentage-basis pro rata despite having the right to do so, other firms may be led to believe there is a reason the inside investor does not believe in the company, which can scare the new investor off.
Participation rights have important downstream consequences. They are complicated and can be confusing—we cover the topic in detail in Choosing a Financing Structure.
Terms when Financing with Convertible Instruments
Interest, valuation cap, and discount are all additional terms that will come up on your term sheet if you are financing with convertible notes or convertible equity.
When negotiating a term sheet, founders need to own the discussion around how their convertible instruments will convert, as the VC they’re negotiating with won’t have information on their cap table. Many founders are shocked when their counsel tells them how much they’re going to be diluted in a priced round after they have raised multiple convertible notes or safes, because they did not understand the interplay between valuation caps and conversion to equity. We elaborate on all of these terms and the details of conversion in Choosing a Financing Structure.
important Make sure you discuss with investors whether convertible notes or safes will be converted in the pre-money or post-money valuation. If you’re negotiating a cap on a convertible instrument, make sure both sides of the table—and your legal docs—are clear on whether the cap is pre-money or post-money.
dangerFounders should also familiarize themselves with how liquidation preference overhang works when it comes to convertible instruments. In your term sheet, you can set up shadow preferred stock or create the discount via common stock to make sure liquidation preference overhang doesn’t happen.
The terms we’ve chosen to designate as “other” are not any less likely to show up on your term sheet than the “essential” terms above. The difference is that the terms in this section have layers of complexity that most founders will need their lawyers to take the lead on or explain to them. You should be able to talk to a friend at a party about essential terms like pro rata rights; but if you can’t casually chat about anti-dilution, don’t worry about it. You’ll communicate closely with your lawyer about any issues they see in the term sheet related to these terms, and you can and should use this section as a reference when you get off the phone with your counsel.
Major Investor Clause
Some founders choose to include a major investor clause, which defines what the company considers to be a “major investor” based on an amount invested, or by number of shares purchased.
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