As a founder of a startup, receiving your first venture capital term sheet can be one of the most exciting times in the early life of your company. Knowing that potential investors believe in your team and your company enough to want to get involved is a rewarding feeling in and of itself. However, knowing what specific terms and provisions to look for in a term sheet can help you address deal breakers early and get the best deal for your company.
Typically a venture capital financing will take one of two forms: convertible debt or preferred equity. A convertible debt round will typically involve promissory notes issued by the company, that are expected to convert into preferred equity upon the occurrence of certain specified events (usually a good sized equity financing). We will discuss the nuances of convertible debt term sheets in a later post. However, it makes sense to introduce a number of these concepts in the context of a preferred equity financing.
Preferred equity, or preferred stock as the lawyers will usually describe it, is equity in a company that is issued to investors in exchange for capital, with certain preferences and rights vis-à-vis the company’s common stock, usually in terms of priority on return of capital and mandatory upside at a sale of the company. These preferences are designed to reward the risk that investors are taking by investing in the company, by offering special voting rights and preferential treatment for the preferred stockholders in certain situations such as public offerings, acquisitions or liquidations. Preferred equity financing rounds come in different flavors and go by different names to reflect the expectations that come with each type of round. For instance, a “Series Seed” round is still preferred stock, but doesn’t come loaded with the same investor preferences as a Series A round. This post will focus on what you would expect to see in a typical Series A term sheet.
Where does the term sheet come into play in all of this?
The term sheet is typically the first document that the startup will sign with an investor. The term sheet will outline the major details of the potential investment, which will eventually be addressed in much greater detail by the final transaction documents. Typically term sheets are not binding, except for a small subset of the provisions governing confidentiality, exclusivity and the investors’ transaction expenses (which the company usually pays). The goal of the term sheet is to give the parties an outline of the key points of the investment, and allow the parties to reach agreement on those key overarching items before fleshing out all of the details of the transaction.
So what are those key overarching items that a company can expect to see when the first term sheet comes across the table?
Price. The first term any founder will examine, and typically the first section of any term sheet, is price. Typically the price is laid out on a term sheet in terms of a pre-money and post-money valuation of the company. Simply put, the pre-money valuation is what the investor is saying the company is worth today, prior to investment, and the post-money valuation is that pre-money valuation plus the anticipated investment amount. The investor’s percentage ownership of the company will then equal the investment amount over the agreed upon post-money valuation. This post-money valuation is calculated on a fully-diluted basis, which means that any shares reserved under a company option pool will be included in the valuation (including unallocated options). As a result, the price term in a term sheet will typically include language that specifies the investor’s percentage ownership following the financing, including shares reserved for an employee option pool equaling a certain percentage of the company’s equity on a fully diluted basis (the option pool percentage typically falls somewhere around 20%).
Liquidation Preference. Liquidation preference refers to how the proceeds of a liquidity event (a sale of the company, but not an IPO – that is dealt with via the convertibility of the preferred stock into common, and the anti-dilution provisions that protect the preferred before that conversion) are allocated amongst a company’s investors. Typically liquidation preference is stated in terms of a multiple of the per-share original investment price (i.e. 1x, 2x, etc.). This means that in the event of any liquidation or winding up of the company, the preferred stockholders will be entitled to receive their investment back, plus the agreed upon multiple of their per-share investment price before any amount is paid out to the holders of common stock. Once the preferred payout is satisfied, the preferred stockholders will either split the rest of the proceeds on a pro rata basis with the common stockholders (if the preferred stock is “participating preferred”), or the rest of the proceeds will be split pro rata only among the common stockholders (if the preferred stock is not “participating preferred”). These rights will be laid out in the company’s certificate (or articles) of incorporation that is filed as part of closing the deal.
Protective Provisions. Protective provisions are essentially “veto” rights held by the preferred stockholders over certain corporate actions. Typically, protective provisions will require a separate vote of only the preferred stockholders in order to approve certain actions, including, but not limited to:
- Altering or changing the rights, preferences or privileges of the preferred stockholders;
- Increasing or decreasing the authorized number of shares of company stock;
- Creating any new class or series of preferred stock having rights, privileges or preferences that are senior to the existing series of preferred stock;
- The repurchase by the company of any of its common stock;
- Any action resulting in a merger, reorganization, sale of control, or sale of all or substantially all of the company’s assets;
- Waiving or amending any provision of the company’s charter or bylaws;
- Incurring a substantial amount of debt;
- Modifying the size of the company’s Board of Directors; and
- Executive hiring/termination and compensation.
The top 3 bullets above are fundamental to maintaining the relative benefits of the preferred stock, while the others are somewhat more focused on the conduct of the business itself. Including these provisions in a term sheet give an investor comfort in knowing that it will have a say in many of the big strategic decisions made by the company, and will thus be able to “protect its investment” in a number of circumstances.
Conversion. Preferred stock will always be convertible into common stock. This is primarily intended to allow the preferred investors to sell in connection with an IPO, but also allows the investor to convert its preferred stock into common in a liquidation situation where the pro rata distribution to the common would result in a higher payout than under the liquidation preference held by the preferred. For instance, in the scenario described in the “Liquidation Preference” section above, if the preferred stock had a 2x liquidation preference but was non-participating preferred (meaning, that when they receive their 2x, they don’t get any more), if the price paid for the company is high enough that it would be advantageous to convert from preferred to common, giving up their preference but also side-stepping the cap, the preferred stockholders would elect to convert to common. There will also always be an “automatic conversion” provision that provides for automatic conversion from preferred to common in the event of an IPO of sufficient size and at a multiple of the original per share price, allowing the preferred investors to participate in the IPO of the company’s common stock.
Anti-dilution. Anti-dilution provisions protect (to an extent) the preferred holders from later sales of stock by the company at a lower price per share than the amount they paid. Mechanically, this protection comes in the form of an increase in the conversion ratio at which that class of preferred converts to common stock. Initially, preferred stock is convertible on 1:1 basis into common stock via a simple equation in the certificate of incorporation: initial purchase price divided by conversion price (which is, initially, the same as the purchase price). If the company sells shares of common stock (or securities convertible into common stock, such as Series B, or warrants, etc.) at a lower price, the conversion price of the affected class is lowered such that the preferred holder would get more shares of common if they convert.
Anti-dilution comes in levels of severity, including the fairly rare “full ratchet” on the one end (which re-sets the conversion price down to the amount of that lower priced later issuance) and weighted average (both broad and narrow) on the other (which takes a view of the impact of the new shares and new issue price in light of the overall outstanding shares of the company). Some version of broad based weighted average anti-dilution is most common, and the key items to watch out for is the list of types of issuances that would not cause a readjustment of the conversion price, such as board-approved option plans.
Board of Directors. In addition to the economic details of a preferred equity financing, potential investors are also greatly concerned with the degree of control they will have over the company following their investment. The protective provisions discussed above are one way to achieve this control. Another is by occupying a seat on the company’s board of directors following the transaction. In a typical early stage preferred equity financing, the investor will request the ability to select a subset of the company’s board of directors. For the investor, this not only provides them with a degree of control over the company, but also gives the company the benefit of having an experienced director on the board, who understands the nuances and challenges of creating a successful business. The presence of a board seat provision in a term sheet frequently relates to how much equity the investor(s) are receiving in the transaction – obviously the more equity the investor(s) get in the deal, the more likely it is that they will request one or multiple board seats to adequately represent their interests. There is a great deal of flexibility in how this provision can be structured, but prospective investors will often seek board participation in some capacity, so this becomes a very common provision in preferred equity term sheets.