We’re living in very interesting times in which we see 20-somethings building Unicorns, even teenagers are not unheard of. Elon Musk is the real-world Iron Man who inspires the millennial generation to dream big and go for their own startup. In such an environment, the craze about being a part of the startup world is only going to increase and we’re all trying to understand it better.
If you’re one of those making an attempt to understand this world and have been reading, you may have come across something called a ‘Term Sheet.’ It is a critical component of a fundraising process as it determines the final deal structure. It can be considered a blueprint for your future relationship with the investor. There are two main elements of a term sheet- economics and control.
The economics of the deal refers to the return the investors will get, and control refers to the amount of control an investor will get to exercise over the business or to veto certain decisions. In this blog, we’re trying to simplify some economic terms in a term sheet.
(Knowledge source of the blog- Venture Deals by Brad Feld and Jason Mendelson)
Valuation
Valuation means the value at which an asset or an investment or a firm is being valued. The valuation at which you and your VC agree will determine how much you are selling your stake. It will also help determine how much you are diluting.
There are two ways to discuss valuation: Pre-money Valuation and Post-money Valuation. Pre-money valuation is how much the company is valued today, before the fundraising. Post-money valuation is how much the valuation is after the fundraising, i.e. pre-money valuation plus the funds raised.
It’s important to be sure of what the investor is referring to. When a VC says that it wants to invest $5 million at a valuation of $20 million, the VC usually means post-money valuations.
This means that the VC is offering you a pre-money valuation of $15 million. What may happen here is that a VC may think that it's buying 25 per cent of the post-money valuation, whereas an entrepreneur may think that it’s a pre-money valuation of $20 million, i.e. 20% dilution. The agreed-upon valuation will determine the price per share an investor pays.
There is no fixed formula to determine valuations. It is a subjective matter dependent upon many internal and external factors. Determining the same for early-stage startups with little or no revenue is especially tricky. Mature startups can be valued on several metrics, such as a multiple of revenue, profit or EBITDA or on the basis of some other operational metrics, such as the number of users.
How the valuation is determined is a vast topic in itself, we’ll leave that for another blog post.
Employee Option Pool
Startups often offer stock options to hire and retain good talent. However, it’s an expensive affair to offer stock options. The size of the pool is taken into account in the valuation of the company. A large employee option pool can lower the actual pre-money valuation and is another valuation trap.
If the VCs suggest a 20% option pool instead of a 10% one, then the extra 10% will come from the pre-money valuation, leading to higher dilution of the existing shareholders.
Let’s look at an example-
Assume a $2 million financing is being done at a post-money valuation of $10 million. Before the funding, there is a 10% unallocated option pool. Now, the investors insist on a provision that the option pool be expanded to 20%. This will translate to post-money ownership of 20% with new investors, 60% to old shareholders, and an unallocated employee pool of 20%. On the other hand, had the option pool remained at 10%, the ownership structure would have been 20% new investors, 10% option pool and 70% would have continued to stay with the old investors.
Early-stage companies tend to have an option pool in the range of 10-20%, while later-stage companies typically have a much smaller percentage of the option pool.
Liquidity Preference
This means how the proceeds will be distributed in the event of liquidation, sale or bankruptcy. To determine the same, the liquidator must analyse the company’s secured and unsecured loans, and the definition of the share capital (both preferred and common stock) in the company’s articles of association. Upon gaining clarity on all of these, the liquidator can decide on a waterfall for the distribution of payments.
Liquidity preference holds importance when a company is sold for less than the amount invested. In common parlance, liquidity preference means a company getting sold or going bankrupt. However, in VC deals, it could also mean a merger or acquisition, the next round of fundraising, or a change of control. It is a liquidity event in which the shareholder recieves proceeds.
There are two important components of liquidity preference: actual preference and participation. It’s also crucial to remember that liquidation preference is specific to a particular series in preference to other series.
Let’s look at an example of actual preference- in the event of liquidation, Series A holders shall be entitled in preference to Common Stockholders to receive a per share amount equal to x times the original purchase price plus any declared but unpaid dividend.
The next component of liquidity preference is whether the investors’ shares are
participating. A participating stock means that the investor will get their preference along with additional proceeds after the preference is returned. There are three kinds of participation: no participation, full participation and capped participation.
No participation: means that the investor gets just his liquidation preference and nothing else. It is also called “simply preferred” or “nonparticipating preferred.”
For example, if an investor buys $5 million of 1x liquidation preference nonparticipating preferred stock and the company sells it for $100 million, then the investor would receive exactly $5 million back if they elect to take ther liquidiation preference.
However, the catch here is, that an investor can always convert their preferred stock to common stock at any time. Let’s assume that the $5 mn investment bought 20% of the company and the conversion ratio is 1:1, the investor can convert it into a common stock and take 20% of the proceeds or $20 million.
Full participation: In this case, the investor will receive its liquidation preference, and share in the liquidation proceeds on an as-converted basis, where “as-converted" means as if the stock were converted into common stock based on its conversion ratio.
This scenario can be viewed as “have your cake and eat it too.” In the above example, the investor would take $5 million off the top and then 20% of the remaining $95 million for a total of $24 million.
Capped participation indicates that the stock will receive its liquidation preference and then share in the liquidation proceeds on an as-converted basis until a certain multiple of the original purchase price is reached. Once the return is greater than the cap, the participation stops. The cap would include the liquidation preference and any declared but unpaid dividends.
There are two primary approaches to liquidation preferences among multiple series of stock:
The follow-on investors will stack their preferences on the top of each other (known as stacked preferences) where Series B gets its preference first, then Series A.
The series is equivalent in status (known as pari-passu or blended preferences) so that Series A and B share pro-ratably until the preferences are returned.
Pay-To-Play
This is another term that is relevant in a down round of financing. In a pay-to-play provision, investors must keep investing pro-ratably in future financings in order to not have their preferred stock converted to common stock (playing) in the company or in order to keep their preferential rights.
Pay-to-play provisions are generally considered good for the company and its investors. It requires the investors to support the company throughout the lifecycle, from the time of original investments. In this case, the investors stay aware that if they do not continue to participate, they can lose all rights associated with the preferred stock.
This rule is inserted into the agreement in order to incentivize the participation of earlier investors. It ensures differing rights for the investors who participate in future rounds and for those who don’t.
However, in certain cases, it is alright if the investors do not participate in future rounds. This can happen when their venture fund is exhausted or they are an angel or strategic investors and do not participate in future rounds as a policy. It could also be family and friends who do not have the budget or knowledge to understand the consequences. Such participants should not be punished to not participating. However, conversion to common stock for lack of follow-on investment is appropriate.
Vesting
Vesting is related to stock options. When an employee is given stock options, the vesting period is defined in such a way that these shares are given to them over a period of time. Generally, the vesting period is four years with a one-year cliff. This means that the employee will have to be around for a year to start getting the stock options. At the end of a year, he will get 25% and the balance over the next 3 years. The industry practice is that stocks vest on a monthly or quarterly basis.
Startups usually employ the strategy of vesting to retain talent. If the employee quits before the vesting period of four years, he gets the percentage of shares which have been vested so far. For example, if he leaves post two years, he gets 50% of the shares promised to him. VCs also impose vesting on founders.
In the case of employee unvested stocks, the same usually go back into the pool to be reissues to future employees. In the case of founder unvested stocks, the same vanishes into either.
Exercise Period
The term exercise period is associated with vesting. Once the stocks are vested, a holder may exercise the option by paying the purchase price to the company. For example, if X has 1000 shares at $0.1/share, he can pay $100 to the company (after the stocks have vested) and own the stock outright.
Current employees usually don’t exercise their vested options as they want to see how much success the company attains. Although, if the cost of exercising is low enough, then there is a significant tax advantage by exercising the options as the same will be subject to capital gains tax instead of normal tax as in the case of options.
Once the employee leaves, then the exercise period determines how much time the employee has to exercise the option. Generally, it is 90 days after the employee leaves. There are some companies that have changed their exercise periods to the maximum legal limit, which is 10 years from the date of grants.
However, employees can take undue advantage of long exercise periods by leaving quickly. The same can be decided on a case-to-case basis, if the employee leaving merits this type of treatment, the company can always choose to extend the exercise period as part of the termination agreement.
Antidilution
Antidilution provisions are important to protect the shareholding of the existing shareholders. There are two antidilution- ratchet- based antidilution and weighed-average anti-dilution.
Full Ratched Anti-Dilution
Full ratchet provision means that if a startup issue shares to the new investors at a price lower than the earlier round with the full-ratchet provision, then the lowest sale price is applied as the adjusted option price or conversion ratio for existing shareholders. It protects early investors by ensuring that they are compensated for any dilution in their ownership caused by future rounds of fundraising. This provision also offers a level of cost protection should the level of pricing fall below that of the initial round.
However, full-rachet provisions can prove to be expensive for founders or investors participating in the later rounds of financing. In essence, it can get difficult for the startup to raise funds in future. Due to this reason, full rachet provisions are usually only kept in place only for a limited period of time. One can also put partial rachets in places, such as half or two-thirds. But these are rarely seen.
Let’s look at an example, consider a scenario in which a startup sells 1 million convertible preference shares at a price of $1 per share, with a full ratchet provision. Now, when the company goes for another round of fundraising to sell 1 million common shares at a price of $0.5 per share.
In this case, the startup will have to issue shares to the existing shareholders at a reduced price of $0.5 per share. In other words, the existing shareholders will have to be given additional shares in order to ensure that their overall ownership is not reduced by the sale of the new common shares.
This kind of situation can lead to several adjustments in which new shares need to be created to satisfy the demands of both old and new investors. The founder can see their shareholding reduce quickly in favour of the old and new shareholders.
A popular alternative to full ratchet provision is the weighted average approach.
Weighted Average Anti-Dilution
Takes into account the interests of founders, and old and new investors and hence a more common approach usually adopted in various deals. This approach takes into
account the amount of money raised by the company in the previous round and at what price. It also considers the amount of money being raised by the company. Further, there are two varieties of weighted average antidilution: narrow-based weighted average and broad-based weighted average.
Well, all of these terms may come across as a mouthful in the first read. But as you dive deep into startup investing, you’ll get these in the back of your head.
There’s a lot more that goes into a term sheet, we’ll cover more in other blogs to keep your interest going.
Disclaimer: This blog was written for a financial services start-up, the website for which has been revamped.
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