When startups and investors start making deals with eachother, they really need to know all about what needs to be in their term sheets. As these are often considered the fineprint of deals between founders and investors, detailed knowledge about them is essential. In this guest post Equidam co-founder Gianluca Valentini is explaining some of the concepts that occur in a term sheet and the general underlying principles.
The difference between an angel round, a seed round and a Series A is that the latter involves institutional investors, such as VC firms. These types of investors usually have more sophisticated requirements in terms of the type of shares they will receive.
The shares that are issued in return for their investment are most likely shares with special rights. The underlying reason is that VCs have to maximize their profit and provide a certain return to their limited partners (LPs).
When raising a Series A round, you will probably issue a new class of shares that has different rights compared to commons shares. These special rights shares will catch more of the future value of the company at an exit event. This is why some people argue that valuations of VC rounds are higher because of the introduction of these implicit rights.
Let’s make an example:
You are issuing preferred shares class A with special rights which sets your valuation at $100,000. The VC invests $10,000 (this is not very likely but we are using these numbers for sake of simplicity) – which entitle them to 10% of your company. It is likely that more value is allocated to these 10% of the shares as compared to the other 90%. As a result the price per share for the two classes is different – lower for the common and higher for the class A. Some stocks have higher price per share because they have higher priority rights over the future cash flows of the company.
Let’s take a look at the most common terms that have economic implications and also the most common practices regarding these terms.
1| Liquidation preference
In the case of an exit, when capital has to be divided among shareholders, the owners of shares with liquidation preferences will receive their money first.
Liquidation preferences can be participating or non-participating.
If they are non-participating, the shareholder has the option to receive his money back first or to split the cash in equal parts with the rest of the shareholders.
The participating liquidation preferences, on the other hand, allow shareholders to receive their money first and then receive a portion of the remaining money as well. Naturally, the participating liquidation preferences are more common.
Liquidation preference come with X’s. Liquidation preference with 1X means you get all your money back; liquidation preference with 2x means that you get twice as much as what you invested and so on.
In general, while 1x is fair, 2x is acceptable in exchange for something in return. Liquidation preference with 3x is too much, in my opinion.
2| Anti-dilution rights
Anti-dilution rights are a protection for investors in a current round from future “down-rounds” of investments (when the valuation is lower than the one in the previous round).
The investor is signalling that he/she is going to invest with a certain valuatio,n hoping that the company will perform better and the valuation is going to increase. However, in the case that the valuation does not increase, the founders are going to bare the consequences in the form of higher dilution.
If you raised for a valuation of 10 million, but in the following round the valuation is 8 million, the price of the previous round is retroactively adjusted to the new (lower) valuation. Thus, you will issue more shares, also to the original VCs without them paying.
To sum up, anti-dilution rights serve as a retroactive protection against down-rounds for investors, and they occur when the valuation is inflated.
Anti-dilution rights are one of the reasons to have a fair valuation in the first place.
The most common type of anti-dilution rights are the full-ratchet. In this case, the price of the first round is adjusted to the price of the new round (if lower), meaning that the first round investors will receive additional shares without any investment. This actually means that you are going to dilute yours and your main shareholders’ shares.
3| Pro-rata rights
Pro-rate rights allow existing shareholders to have a first call on newly issued stocks up to the amount needed to prevent dilution. This means that existing shareholders are going to preserve the same percentage of the total number of shares, no matter the number of shares issued.
As a result, when issuing new shares, you always need to offer them first to the holders of the pro-rata rights before offering them to external investors.
This is a standard term that you will usually have in the term sheet from any VC. It is important to note that the investor has the option to invest first, but he/she is not obliged to do so.
4| Redemption rights
This is another type of protection for investors that gives them the right to ask to redeem the shares after a certain period of time (e.g. 5 years) by asking the company to buy them back at the original purchase price (plus dividends). This is done to protect investors from being stuck with a company that is not likely to exit soon.In most cases, VC funds have a lifetime of 10-15 years. At the end of this timeline, the fund needs to return the capital to the LPs, which is where the redemption rights come in.
Exercising the redemption rights is somewhat tricky, because some companies might not be able to afford buying back the shares.
However, this term is not very common and even if it is present in the term sheet, it is likely not going to be exercised.
5| Founders’ shares vesting
A VC can give you vesting. What happens in this case is that you give back your shares and you accrue the right to own them over time. The logic behind it is very similar to the underlying principles of employee stock options.
This term is not uncommon in the private investment market. However, it is a very bad signal if included in any term sheet. It basically says that the VC believes more in your business and the trend of the market rather than in the people who started the company. It could also mean that the VC does not consider the founders more than employees of the firm.
Vesting could be quite disadvantageous to founders. For example, in the case of an exit before the end of the vesting period, a founder does not have right to all of the shares, but only the ones already vested. In addition, if the founder leaves the firm before the vesting is complete, he will depart without part of the shares that were entitled to him in the first place.
All terms in the term sheet can be negotiated. Instead of focusing on the small details in the terms, you should focus on the reason why the VC is requiring this term.
What about your experience? Have you already dealt with these or similar terms when negotiating with investors?
The content provided to you by means of Term Sheet: Common Terms & Practices To Be Aware Of is for informational purposes only and is not intended to be a substitute for professional legal advice. We do not engage in the practice of law and do not provide legal advice and opinions regarding possible legal rights, remedies, defenses, or strategies. Therefore, before taking any action based on the presented information, make sure you consult with the appropriate legal professional(s). We hereby waive any liability to you for any reliance on the content of this video – such reliance shall be solely at your own risk.