For a first-time founder (or even an experienced one), reading a term sheet from a venture capitalist might feel like reading a foreign language. And while a term sheet does contain a myriad of terms, the most important ones can generally be thought of as following into three categories: 1) Economic Terms, 2) Legal Terms, and 3) Investor Financial Protection Terms. This post will explain important terms in each of these categories in order to help demystify term sheet reviews.
These terms affect the economics and financials of a startup. They can also play a role in allocating proceeds upon a liquidity event, such as a sale or initial public offering.
Valuation generally refers to the “pre-money” valuation of the company and is expressed as an aggregate equity value for the company (e.g., the per-share purchase is based on a pre-money valuation of US$15 million). In addition, term sheets sometimes reference the “post-money” valuation of a company. The term is equally important in both instances, as it drives the key aspect of the financing: how much or what percentage of the company the investors are purchasing. These valuations include both the “enterprise value” of the company and the existing cash on hand, which is generally referred to as the “equity value.”
A founder derives the per-share price by dividing the pre-money valuation by the number of shares. The number of shares is generally expressed on a “fully-diluted basis” that considers the outstanding shares, plus any shares reserved for issuance upon exercising or converting outstanding securities (options or warrants), and, often times, the shares reserved for future issuance under the option pool and may include (subject to negotiation with the investor) an increase in the number of shares to be reserved under the option pool in connection with the financing.
2. Investment Amount and Capitalization
The investment amount is usually one of the first terms that appears on a standard term sheet. This term tells a founder the total amount that the deal will raise. An equally important term included in a term sheet that relates to the investment amount is the capitalization table that shows both the pre-financing and post-financing capitalization of the company on a fully-diluted basis (see Issued and Outstanding Shares Versus Fully Diluted Shares). Based on this table, a founder can determine the percentage of the company that each relevant entity will own before and after the deal is closed. Referencing the capitalization table helps founders understand the dilution they will experience as a result of the financing (see What You Need to Know About Capitalization Tables).
3. Liquidation Preferences
Liquidation preference grants a company’s preferred stock investors special rights of return upon a liquidation event (e.g., a sale of the company or an adverse event affecting the company’s assets, such as a dissolution or bankruptcy event). Companies refer to these rights as “preferences” because investors holding preferred shares will have priority over the common stockholders when a liquidation event occurs. The three types of liquidation preference are: 1) non-participating preferred, 2) participating preferred, and 3) capped participating preferred.
Preferred stock with a non-participating preference is the most favorable option for a company. In this scenario, investors have priority over common stockholders in that they receive a return on their investment along with any accrued and unpaid dividends before the proceeds are shared pro-rata among the common stockholders. However, in the situation that — based on the company’s valuation — these preferred stockholders would have received a higher amount if they had converted their shares into common stock, then they may forgo their liquidation preference and instead be treated as if they had converted to common stock.
By contrast, preferred stock with a participating preference is the most favorable option for an investor. Similar to a non-participating preferred, investors with a participating preferred liquidation preference will receive a return on their investment along with any accrued and unpaid dividends prior to the distribution of proceeds to common stockholders. In addition, preferred stockholders with this type of liquidation preference will be treated as if they had converted to common stock and may participate on a pro-rata basis in any remaining proceeds available to the common stockholders. As a result, these preferred investors get to essentially double-dip in the proceeds.
A capped participating liquidation preference splits the difference between the two types of liquidation preference described above. Investors with a capped participating liquidation preference will receive all the rights that come with participating preferred, but their overall return will be capped. So while they will be able to participate on a pro-rata basis in any remaining proceeds available to the common stockholders, these investors will no longer be able to participate once their return reaches the stated cap.
Founders may see a multiple written before the liquidation preference (e.g., 1X, 2X). This number indicates that preferred investors may receive a specific multiple of their original investment before any proceeds can be shared with the common stockholders. The higher the multiple, the more investor-favorable the liquidation preference is (see 4 Key Differences Between Common Stock and Preferred Stock).
A dividend is a payment that a company makes to its stockholders out of its profits, either in the form of stock or cash. Dividends can be thought of as either cumulative (also referred to as accruing) or non-cumulative. A non-cumulative dividend is only payable to a company’s shareholders if the company affirmatively declares a dividend for that year. By contrast, a cumulative dividend accrues every fiscal year regardless of whether the company declares one. Some term sheets even require unpaid cumulative dividends to accrue interest while waiting to be distributed.
In general, founders should treat any cumulative dividends with caution. If investors insist upon cumulative dividends, the founder should build in protections — for instance, by ensuring that the dividends are only paid if a liquidation event, such as the sale of the company, were to occur. Additionally, cumulative or accruing dividends pose additional accounting complexities.
5. Option Pool Size
In a term sheet, an option pool usually means an unallocated pool of shares reserved for issuance to future employees or consultants under an equity incentive plan. Because a company’s pre-money valuation typically includes the option pool, these future issuances have already been factored into the calculation for each entity’s post-financing ownership percentage. Therefore, when these options are actually granted, they will not impact the preferred investors’ ownership percentage — which is calculated based on the assumption that the options have already been granted and exercised. The larger the option pool is, the greater the effect will be on the ownership percentages of common stockholders (i.e., founders and employees).
Although the legal terms in a term sheet can only affect a company’s financials indirectly, the terms have a direct impact on the investors’ control and decision-making powers.
1. Protective Provisions
“Protective provisions” refer to terms in a term sheet that provide investors with the power to grant final approval of certain corporate actions. Therefore, even if a board approves a corporate action that a protective provision covers, the company will still need to obtain the approval of a specified percentage of preferred stockholders before being able to implement such action (see 4 Key Differences Between Common Stock and Preferred Stock).
While most protective provisions are fairly standard (such as those related to fundamental changes in the company’s business, amendments to a company’s charter or bylaws, etc.), founders should always analyze each protective provision included in the term sheet to determine if it is appropriate under the circumstances. Founders should also try to ensure that protective provisions stipulate that they shall only remain in effect if a certain number of preferred stockholders with such provisions remains outstanding. Additionally, founders should avoid agreeing to high voting thresholds for these protective provisions, which could give any hold-out investors a great deal of leverage.
2. Board Representation
The term sheet will also specify the desired composition of the company’s board of directors and who votes for each board seat. For example, after securing financing, a startup might establish a three-member board, with the company’s founders (common stockholders) controlling the election of one seat, and the preferred investors controlling the election of another seat. The last of the three board positions could be independent (as is customary), although, depending on the negotiation process, either the founders or the preferred investors could elect that seat.
The ability to elect a majority of the board is very advantageous, so founders should try to negotiate for it if they have the leverage to control board representation. Founders should also try to ensure that the terms for board representation specify who will represent the investors in order to guarantee the involvement of a more senior or experienced representative instead of, potentially, a junior associate with limited experience.
Investor financial protection terms refer to terms in the term sheet that help protect investors’ economic expectations against changes brought on by subsequent financial transactions.
1. Conversion Rights
Conversion rights refer to investors’ ability to convert their shares of preferred stocks into shares of common stocks. The two types of conversion rights are optional and mandatory.
Optional conversion rights are tied to the investors’ liquidation preference. If investors have a non-participating liquidation preference, they can either choose to take their liquidation preference or exercise their optional conversion rights, convert their shares into common stock, and share in the proceeds directly with the common stockholders. Optional conversion rights are usually not negotiable.
Mandatory conversion rights will force investors to convert their preferred stocks into common stocks if certain conditions were to occur. These conditions are usually negotiable, and founders can try to make them more company-friendly by, among other steps, 1) eliminating any price thresholds for conversion, 2) asking for a majority threshold rather than a supermajority if preferred stockholders’ consent is required for the conversion, and 3) conditioning the conversion based on net proceeds rather than gross proceedings.
2. Anti-Dilution Provisions
Anti-dilution provisions are terms that protect investors against future securities and stock issuances that are priced at a level lower than the price paid by such investors. While preferred stock is usually converted to common stock at a 1-to-1 ratio, when these anti-dilution provisions kick in, they increase the conversion ratio, enabling preferred investors to get more common stocks and helping to protect those earlier investors from the dilutive effects of later investors getting more shares for the same amount invested. The two general types of anti-dilution provisions are full-rachet and weighted average. (Although weighted-average provisions can vary, the most common type is referred to as broad-based weighted average).
Founders should be extremely wary of full-rachet adjustments, which are almost never seen. When a full-ratchet anti-dilution adjustment kicks in, it essentially “rachets” down the earlier investors’ conversion price to the lowest price that the company’s securities were ever issued at.
By contrast, weighted-average anti-dilution provisions adjust the conversion ratio by taking into account both the new price for the company’s securities as well as how many shares were issued at this price. Consequently, the impact on existing stockholders is much less severe and would only be significant if the new round is priced much lower and the number of shares issued is extremely high.
3. Drag-along Rights
These terms enable preferred investors to obligate other common stockholders to vote in favor of certain qualifying liquidation events. When negotiated correctly, these provisions can help secure approval for transactions that are being blocked by a few holdout investors. However, founders should ensure that term sheets include sufficient conditions to protect them from having their company sold at a value that will wipe out the founders’ entire equity stake as a result of such drag-along rights. For example, these conditions could include requiring a supermajority vote of the preferred stockholders to enact any drag-along provision and adding minimum price thresholds for the types of liquidation events that could enable the use of the drag-along provisions.
This overview of the three main categories of terms included in a preferred stock financing term sheet aims to translate common lingo so that navigating term sheets feels achievable. Founders that understand key term sheet terms are better equipped to help their companies take the next step toward growth and success.