At every investment stage, management and investors seek to appropriately balance risk and reward. This balance plays out in both the economic and moral dimensions.
Investors invest money. CEOs and management teams invest time and life energy. Especially in early stage companies, top teams accept significant cash income haircuts, betting that their equity ownership stakes will more than compensate. At every stage of company growth, each executive has a right to reassess that risk / reward balance. If ever the risk associated with staying at the company is not adequately offset by an achievable equity-based reward, it is perfectly legitimate for a CEO or key executive to leave.
Similarly, investors balance risk and reward. At the macro level, an investor will choose an investment class. Some investors are angels or seed stage investors. Others focus on early stage VC funding, or late stage, or venture debt, or hedge fund investments, or public company investments. The further along the investor continuum, the more traction companies exhibit — making an investment less risky. This changing risk profile is (and must be) reflected in the corresponding rewards that occur when a company becomes successful.
Investors also balance risk and reward at the level of the deal. Each prospective investment is different. In some cases, it’s highly competitive. When that is the case, the investor’s greatest risk may be to lose out. In most investments, the investor has significant leverage, and often uses it to impose downside protections and upside sweetening levers in the deal structure. If an investor determines the investment risk is not offset by sufficient reward potential, then that investor is right to decline the investment and move on.
As the tech company CEO, it is important to understand these risk / reward factors. You must assess the heat of your deal. Further, you must be informed on the levers available to investors to drive a more favorable (to them) balance of risk and reward. Only then will you have the knowledge necessary to negotiate well.
It is also important to appreciate the moral principles behind the levers available to investors. As CEO, you and any new investors must protect the legitimate rights of those who have previously invested time or money. This may be your legal duty, but it is surely your moral duty. Early investors, founders and departed employees may (to varying degrees and depending on circumstance) have claims to exit proceeds that should be respected by a new investor.
The term sheet is your blueprint for achieving this balancing of risks and rewards. For both economic and moral reasons, it’s important to get it right. Since the term sheet guides terms in the final definitive documents, it’s best to clarify key questions up front. It makes no sense to defer tough conversations for a time when you have less leverage (when, for instance, you’re under a no-shop agreement).
The term sheet is all about economics and control. It lays out the factors that will govern your relationship with a new investor — the economic consequences that will occur under downside and upside scenarios, and how authority and control is shared amongst investors and management. While the final definitive documents might run over 100 pages, the term sheet is usually much more summarized (usually between 1–10 pages in length). The day you receive your first term sheet in a funding cycle will probably feel like a good day. But once it arrives in your inbox, the real work begins.
Before you can sign, you must closely vet, clearly understand, and knowingly agree to every major deal point. This requires preparation before you receive a term sheet, close legal review once you do receive it, and then diligent negotiations to finalize and approve it. After term sheet signature, there is nothing more detrimental to final close than to be stuck on a debate about an important point not covered by it.
So, the terms matter. The good news is they’re fairly predictable. I’ve divided these terms into “the basics” and the “heads up terms”. The latter refers to the terms that most significantly impact economics and control. They are the ones that are most often misunderstood.
Here we go.
- Equity vs. debt
- The capitalization table
- Common stock
- Preferred stock
- Stock options and warrants
- Vesting and exercise
- Employee pool
- Financing series
- Liquidity event
“Heads up terms”:
- Convertible note: discounts and caps
- Liquidation preference
- Conditions precedent to a financing
- Protective provisions
- Right of first refusal and co-sale
- Pro-rata rights
- Board composition
In this chapter, we will cover “the basics”. In the next chapter, we will cover the “heads up terms”.
To help bring to light how important terms are, consider this example.
Two founders start a company. Investor Y comes in at the seed stage with a $500K investment on a convertible note. The note includes a discount and a cap. The discount to the A round valuation is 30%, to be applied as long as it yields more shares at conversion than applying the cap, which is set at $6M. Later, in the A round, Investor Z invests $5M. The pre-money value is set at $10M.
The following shows the difference between applying the cap and applying the discount, under three variations of A round terms for calculation: the pre-money method, the post-money method, or the dollars invested method. This creates six different scenarios. For each, the method of calculation is shown below in the spreadsheet.
I am indebted to Brian Royston, a talented long-time Silicon Valley temp CFO, for help with the math. Brian has worked through these calculations with countless VC backed tech company CEOs, so I was grateful to have his help.
Under this scenario, the pre-money is fixed and other values are determined based on the pre-money valuation.
The Post-Money Method
Under this scenario the post money is fixed and values are determined accordingly.
The Dollars Invested Method
Under this scenario, the values are determined based on the dollars invested.
As you can see, in all cases the $6M cap is more favorable for the noteholder than the 30% discount. Based on the cap, the noteholder ends up with somewhere between 5.1% and 5.3% of the company, depending on whether the A round calculation is based on the pre-money method, the post-money method, or the dollars invested method. The Series A investor ends up with somewhere between 31.6% and 33.3%, and the founders end up with between 61.5% and 63.2% of the company.
Let’ presume the A round terms stipulated the dollars invested method. Let’s also assume it was the final investment made in the company. Remember that both Investor Y and Investor Z are part of the same preference class, sharing all preference terms. Furthermore, let’s say Investor Z included in the terms of investment a “3X liquidation preference with full participation”.
Four years later, the company sells for $20M. Here’s how the money would be distributed. First, Investors Y and Z would receive the 3X liquidation preference: i.e. $5,807,692 X 3 = $17,423,079. Then, these two investors would have full participation rights — meaning that they would also receive 32.3% + 5.2% = 37.5% of the remaining money — i.e. 37.5% X $2,576,921 = $996,345. In total, investors would receive $17,423,079 + $996,345 = $18,389,424, split ratably between Investors Y and Z. In other words, of the total $20,000,000 transaction, the two founders plus all other employees would receive just $1,610,576.
Now let’s change the terms. Let’s say the A round was based on the pre-money method. Let’s say Investor Y’s convertible note only had a 30% discount, with no cap. And let’s say Investor Z’s A round terms included just 1X liquidation preference, with no participation. Let’s also assume the same exit price of $20M. With just these changes to terms, Investors Y and Z would receive $7,619,048 at exit, and founders would receive $12,380,952. In other words, under this scenario the founders would take home cash worth almost 8X the previous scenario.
You get the point. Terms matter.
On a convertible note, investors are economically motivated to:
- Maximize the percent discount (the normal range is 10% to 30%)
- Minimize the cap
- Impose a high nominal interest rate (the normal range is 4% to 12%)
On a SAFE note, investors are economically motivated to:
- Maximize the percent discount (the normal range is 10% to 30%)
- Minimize the cap
In an equity financing, investors are economically motivated to:
- Minimize the price per share paid for a given percentage ownership
- Maximize the pre-money size of the employee stock option pool
- Maximize liquidation preferences
- Have full participation
- As a preferred shareholder, have unimpeded drag-along rights for common shareholders
- Have ability to drag along founder shares on all votes if founder leaves
- Have full-ratchet anti-dilution to protect from a future down round
- Impose pay-to-play on previous investors
- Require a no-shop clause in return for signing the term sheet
- Keep significant flexibility to back away from the deal at any time during diligence
- Maximize the protective provisions to insure maximum control after an investment — such as supermajority approval of many company actions
To negotiate the term sheet from a position of strength, you must understand terms, their consequences and investor motivations. If you do, you can bargain intelligently.
So let’s dive in.
Equity vs. debt
When you receive equity financing, you relinquish a percentage of ownership in your company in return for cash. Lots of factors can impact how much equity you give up, and the rights associated with that equity — but that’s the essence of it.
When you receive debt financing, you borrow money with interest, and do not give up ownership. As a general rule, creditors require more downside protection than equity investors. In a liquidation, creditors must be paid first. Only after all debts have been extinguished can owners of equity participate in liquidation proceeds.
Certain types of loans include equity components. The lightest version of this is the term loan with warrants. In this instance, the bank includes in the loan deal a small number of warrants, with the right to convert into equity at a predetermined strike price (which may be exercised when the company has its liquidity event). In a venture debt deal, where the risk profile is higher than a term loan from a commercial bank, the interest rate tends to be much higher, and the warrant coverage more significant — but it’s the same idea.
In a convertible note, the debt instrument has a right to convert into equity — at a discount to the next equity funding round, or with a cap applied at the next funding round, or both. This conversion step is usually automatic, based on the trigger of a closed equity funding round. Until conversion, it is considered debt, with all associated rights.
The Capitalization Table
The cap table is the ledger that tracks ownership by shareholder. All issued and outstanding shares, plus all options and warrants to buy shares should be reflected in your cap table. The totality of shares — both those issued and outstanding, and those that would be issued if all options and warrants converted — is referred to as the fully diluted shares.
Fully diluted shares include shares and options owned by founders, shares and options owned by employees, shares and warrants owned by investors, and the option shares in the employee stock option pool that have been approved but not yet distributed. As to shares, each share class is shown — both common and preferred. For preferred shares, the preference class is shown. The date of each issuance or option grant is identified, with preference rights shown. As to options, the vesting status and strike price of each tranche of options is shown.
Because of preference rights such as liquidation preference and participation, the percent ownership of shares can be (and often is) different than the percent of liquidation proceeds at a sale. As the company example presented earlier shows, this divergence can be significant, driven by the terms of the investment.
The cap table is likely to be included (in summary form) in an investor’s term sheet. Before you sign a term sheet, you must clearly understand the effects of preference rights. Towards this end, it is helpful to create a detailed pro forma cap table based on the terms, and conduct a waterfall analysis. In this waterfall analysis, you identify the economic outcomes for each investor (including founders and employees) at different exit prices (i.e. $10M vs. $20M vs. $50M vs. $100M). This will help you fully understand the impact of terms on every stakeholder before you commit to the terms.
Preferred shareholders have unique rights that supercede the rights of common shareholders. These preferences — such as liquidation preference, participation, anti-dilution, and control related provisions — can be exercised at will by the preferred shareholder. Upon a liquidity event, a preferred shareholder will convert to common if and only if it makes economic sense to do so. Otherwise this shareholder will claim the right of preference.
Common shares are secondary to the rights of preferred shares. The common shareholder can be completely washed out in a liquidity event, if fulfilling the rights of preferred shareholders takes up all of the liquidation proceeds.
Stock options and warrants
Stock option and warrant grants extend a right of equity purchase to an employee or other party. The equity purchase right includes a strike price — the per share price at which the shares may be purchased. Stock option grants are usually reserved for employees, independent board members and advisors, whereas warrants are most often found as a part of financing transactions. Employees receive Incentive Stock Options (ISOs), which have favorable tax treatment. For instance, no federal tax is owed upon exercise of an ISO. Independent board members and advisors receive Non-qualified Stock Options (NSOs). When NSOs are exercised, if the fair market value at the date of exercise is greater than the strike price, federal tax is owed.
Vesting and exercise
Option grants usually include a vesting schedule — which establishes the time-based milestones upon which a recipient gains the right to exercise the option. For employees, the prevailing vesting schedule is “four year vesting / one year cliff”. This means that for the first 12 months, zero option shares vest. From month 13 to month 48, 1/36th of the total granted shares vests each month.
When an employee leaves a company, it is common for the employee to be required to exercise option shares within a short period of time — often 1–3 months. This is often a difficult decision for the departing employee, who must purchase the shares with real cash, without knowing whether the company will ultimately experience a successful exit.
The employee pool is the pool of unallocated shares that have been set aside for future option grants. The size of this pool is often a hotly contested negotiation point in finalizing a term sheet. New investors want the pool to be as big as possible, so that no additions to the option pool will be required down the road (which would create dilution of their ownership positions).
Management is economically incented to minimize the addition to this pool in a new round of funding. The best way to resolve the debate is for you to prepare an options budget, with a schedule of positions you plan to add and the percentage or number of options shares you propose to grant. This will enable a rational resolution of the debate.
It’s not uncommon for founders and early stage employees to be granted restricted stock, as opposed to options. A restricted stock is an actual share of stock (not an option). The restriction is that the company has the right to buy back the stock, based on a vesting schedule (usually the same time-based milestones as with a stock option vesting schedule). If you don’t pay for the stock, you will be taxed on its value. If you have made an 83(b) election within 30 days of the grant, you can pay the tax based on the value at grant. If not, you will need to pay the tax based on the value at vesting.
So if your term sheet involves a restricted stock grant to founders or employees, be sure to complete the 83(b) election within thirty days.
The prevailing convention is to refer to an equity financing round as a series. Angel investments are usually made as SAFEs or convertible notes, so these are not considered a series. The first series is usually the Seed Series, followed by Series A, B, C, etc.
The designation of the series ensures that all can keep track of different preference rights and terms.
An equity financing round includes the pre-money valuation (the valuation of the company prior to new capital) and the post-money valuation (pre-money valuation plus new capital). When an investor proposes a valuation for your company, be sure to ask whether she is referring to pre-money or post-money. You’re likely to think she means the former, while she’s likely to mean the latter.
A liquidity event is any event in which one or more shareholders sells shares in return for cash. For instance, the board might give approval for the CEO or other executive to sell a small number of shares to buy a house.
Liquidity events that cause a change of control — where more than 50% of the ownership of the company changes hands — triggers many rights for preferred shareholders, and often (via employment agreements) with employees.
A complete sale of the company is referred to as a full liquidation event; in such an event, all sale proceeds are distributed to stakeholders based on their creditor status and equity preference rights.
Creditors may possess a right of conversion to equity shares. Preferred shareholders possess the right of conversion to common shares. Preferred shareholders have sometimes converted to gain increased control over certain common shareholder rights, such as board seats. These conversion rights always affect the distribution of proceeds at exit. For these reasons, conversion rights are important to understand.
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If you want to become a student of term sheets, check out the National Venture Capital Association website’s “Model Legal Documents” section.1 It includes standard templates for the most common legal documents and terms, including a model term sheet.
- Model Legal Documents, National Venture Capital Association, 2018, https://nvca.org/resources/model-legal-documents/.
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