It can be overwhelming for an entrepreneur to deal with the financing procedures (term sheets included) for the first time. Luckily for you, there has been an increase in the amount of information available and shared over the years, and an effort to simplify the documents and processes. Knowing how everything works will save you not only a bunch of bucks, but also a lot of headaches.
But what is a term sheet anyway?
A Term Sheet outlines the basic conditions (terms) of a proposed investment. It is not a legally binding document, but only a foundation for the definitive financing agreement.
Terms and Structure (or How does it work?)
When it comes to investment, venture capitalists only care about 2 aspects: money and control. At the end of the day it is all about the return that the investors will get and the mechanisms that will allow them to exercise power over the company or to veto certain decisions.
The key here is to find a balance between both the founders’ and the investors’ interests.
Before starting, it is important to understand the types of stock that are part of every term sheet:
- Preferred Stock: Stock, usually issued by investors, which comes with certain rights attached (some of them will be described in this article). The terms Series A, Series B, etc., refer to the class of preferred stock issued at each fundraising round.
- Common Stock: Stock that allows voting rights in certain matters of the company. Owners of common stock are the last ones to receive the company’s assets, for instance in liquidation events.
Let’s now take a look at the most important sections in a term sheet (in an equity structure):
First, we need to understand two basic concepts: Pre-money and Post-money valuation. Pre-money valuation is the value of the company before the investment, while post-money valuation is the pre-money valuation plus the new investment. The valuation is affected by two elements: option pool and warrants. An entrepreneur should have several investors interested in order to better negotiate prices. In early rounds the investors will be looking for lower prices. If no new investors come, they will want flat (financing rounds with equal price) or down rounds (with lower price than the previous); When there are new investors the story changes: the new ones will fight for lower prices while the old ones will argue for higher prices for the latest (to limit the dilution – reduction in the proportional ownership). There are a lot of different interests to combine, so one should be smart when picking the investors, especially the first ones, as they can change the course of the company (for better and for worse).
Option pool: is the reserve of shares of stock held for the employees. It is used to attract people to the company and to reward and motivate the employees. Having a larger option pool might seem wonderful, but it lowers the pre-money valuation.
Warrants: certificates that entitle the holder to buy a certain amount of securities at a specific price within a particular timeframe. They also contribute for a lower valuation of the company and bring an unnecessary complexity.
This means that in a liquidity event, a certain multiple of the original investment per share is returned to the investor before the holders of the Common Stock receive any money.
Liquidation preferences are easy to handle when there’s only one series of investors (Series A). With several series of stocks we have two scenarios: the series are equivalent; or follow-on investors get their preferences first (series B receives before series A). Don’t forget that if your term’s negotiation with your first investors is poor, it is very likely for you to have the same kind of trouble in the terms with the following series.
Please also note that liquidation preference is different from participation. Participation means that after the payment of the liquidation preference the remaining assets are ratably distributed between the investor and the holders of the common stock on a common equivalent basis (it is usually called double dip). In case of capped participation the investor participates in that distribution, but only until it reaches a certain multiple return.
Board of Directors:
This section describes how the board of directors is chosen. Having a small board is much more efficient, so it is important to find the right balance between founders, investors and outsider representation. Sometimes investors want to have board observers. They are observers only in theory (even though they cannot vote). Having too many will affect and even delay the decisions in the company.
These constitute veto rights that investors have on certain actions (like a sale, financing, etc.). More than for controlling the company, their goal is to protect the assets of the investor. He will like to have them, as opposed to the Entrepreneur, which hopes for having none or only a few. The Entrepreneur should be very cautious about these protective provisions because unlike in the board level (where member’s self interested positions are conditioned by the fiduciary duties) the actions here are almost always about self-interest, slowing decisions and impacting for instance future financings.
When you have several series of stocks, there are two scenarios: the new series have the same protective provisions, and in the end they vote alongside the other investors as a single class (which will be much simpler for the Entrepreneur to manage); or the new series want different votes, as they have different interests from the other investors (be aware of the fact that small investors with different veto rights from the other series can control much more than they should).
In case of a sale, the majority of the shareholders can “drag along” the others. It can be a good thing, since it removes the possibility of small investors blocking the operation until higher payments are achieved. One way of compromise is to make the drag-along agreement regarding the majority of the common stock instead of the preferred (to create a majority a preferred investor can always convert some of the holding to common, which lowers the liquidation preference and benefits the holders of the common stock).
The basic notion behind this is that if a non-economic transaction occurs (something that changes the number of shares with no impact in economics) the proper adjustments should be made. Investors always think about down rounds (when the company issues shares at a lower price than the previous rounds), and that’s why there are two types of provisions: Full-ratchet anti-dilution and weighted average anti-dilution. In the first type, if the company issues shares at a lower price, the previous series’ price is reduced to that new price (if the previous investor paid 1€ per share for 100 shares of preferred stock and the additional stock is now at 0.5€ per share, each one of those 100 shares should be converted into two shares of common stock). In the weighted average anti-dilution there is a conversion price adjustment instead of issuing more shares.
The investors have to participate in later financings in order to keep their preferred stocks from converting in common stock (as well as the rights involved). This guarantees that the investors are supporting the company, and reduces the liquidation preferences in case of conversion.
Next time in this financing structure section we’ll cover convertible notes. Don’t miss it!
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