Our approach for reviewing deals starts with the notion that “money is temporary; control is forever.” From that perspective, we are compelled to look first at the control terms in a deal before turning our attention to financial terms. The economics of a deal and the resulting control of the company are the only things that really matter in reviewing a term sheet (and a good pitch should preemptively address those most important concerns).
The first way an investor intends to manage their relationship with a company is by their controlling a seat on the company’s Board of Directors. Typically, investors settle for a “neutral” board of three or five people: half the board represents the Preferred investors, half represents the Commons or Founders, and the odd member should be a mutually acceptable third party. Board seats come with fiduciary responsibilities. Often, an angel that holds a non-voting Observer seat can influence the board discussion without taking on the added fiduciary responsibility. In general, as an angel, expect the lead investor in an early-stage deal to take the board seat. But in any pitch or term sheet negotiation, we want to learn, by name, who is or will be controlling the company.
A second control comes with Protective Provisions that require the company to get the consent of at least the majority of Preferred shareholders in order to alter rights, preferences, or privileges of the Preferred holders; increase or decrease the authorized number of Common or Preferred shares; create any new class or series of shares; redeem or repurchase Common stock; enter into any reorganization, merger, acquisition, change of control, etc.; change the company’s charter or bylaws; change the size of the Board of Directors; declare dividends; or issue debt in excess of $X. This term won’t usually be talked about in a pitch, but it should be understood from reading the accompanying term sheet.
The final control term, which should be non-negotiable, is the right for Preferred shareholders to convert, at any time, their Preferred into Common stock at a set conversion rate (usually 1:1). There are also sometimes automatic conversion features put in place, and the thresholds for automatic conversion are important to negotiate, but regardless of at what level those thresholds are set, investors want to ensure that automatic conversion is the same for all Series of Preferred stock.
Of the economic terms, Enterprise Valuation (EV) is the most important term, and this will be spelled out in a pitch for funding. The higher the valuation, the more profitable the company will need to be to command a sufficient exit multiple for angel investors to make a fair return. Pre-money and post money valuation calculations are straight forward: Investing $500,000 at a valuation of $2 million = $2,500,000 (after investment) divided by the investment amount of $500,000 = 20 percent ownership post-money. Entrepreneurs often speak in terms of pre-money valuations. The pre-money would simply be (in this example) $500,000 investment / 25 percent of the company’s shares = $2,000,000 valuation. Investors should always think about post-money fully-diluted ownership. “Fully diluted” means that every potential claim on the company’s equity is factored in–all Common and Preferred shares converted to Common, all options issued (whether “in the money” or not), all warrants as if exercised, and all convertible debt as if converted.
Liquidation preference is the second most important economic term after valuation. Liquidation preferences are not very important if the company executes its business model better than expected, but become critical if the company underperforms (as most often happens) and the entrepreneur sells the business for less than the amount of capital invested. Liquidation preferences are written in term sheets along the lines of: “In the event of any liquidation, change of control, or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of Common Stock a per share amount equal to X times the Original Purchase Price plus any declared buy unpaid dividends. Typically, the liquidation preference is set at 1X-1.5X. This term may be talked about in a pitch for a convertible note deal. It likely won’t be mentioned in the pitch for an equity deal, but needs to be included in the term sheet.
There’s a separate, but related term called “participation”: Participation refers to the way Preferred investors will receive their share of liquidation proceeds on an as-converted (to Common) basis. Full participation means that investors take their liquidation preference amount, then share ratably in the whatever remains to be distributed. Capped participation means that investors take their liquidation preference, then share ratably in the remainder up to a cap or limit amount. No participation means that after the investors take their liquidation preference, they do not share in divvying up what remains. No participation means that the investor will receive either their liquidation preference or their stock will convert into Common shares and the investor will get their as-converted basis. If there is no mention of participation in the deal terms, it means that there is no participation with the liquidation preference.
A side note: Liquidation preferences are very important in convertible note deals, as each as-converted share contains one preference. Here’s a very interesting blog post on this topic. Later stage investors (the Series A’s that follow the Seed investors or the Series B investors after the Series A’s) will usually argue for the same preferences that earlier investors received, so that after several rounds of financing, the deal will usually contain “stacked preferences,” with whomever is at the top of the stack receiving the best outcome from a liquidity event.
Bear in mind that when it comes to preferences, “liquidation” refers not just to a company going out of business, but also to a merger, acquisition, sale of business, or any change of control. (It does not refer to an IPO—those are simply funding events.) Investors get either the liquidation preference and participation amounts (if any) or what they would get on converting their note or Preferred shares to Common stock at the time of the triggering event. They don’t get both. Again, in the case of full participation, the investors get their participation amount and then receive what they would get on a Common holding basis.
Anti-dilution terms are the last key economic element to touch on here. These are the terms that protect (somewhat) early stage investors in the event that a company issues additional equity shares. Anti-dilution is used to guard investors in case a company issues equity at a lower valuation than in previous financing rounds. There are two basic varieties: weighted average anti-dilution and ratchet-based anti-dilution. Full ratchet means that if a company issues shares at a lower price than in the Series with the ratchet provision, then the earlier Series is automatically re-priced (more shares issued) to the price of the new issuance. Most deals contain weighted average anti-dilution.
There are some variations on weighted average anti-dilution (broad-based or narrow-based). Feld provides an excellent explanation on these provisions. Again, anti-dilution terms should be clearly written in the term sheet.
We’ll post more on this topic at a later date. Meanwhile, we recommend strongly that you pick up a copy of Brad Feld and Jason Mendelson’s informative and very readable book: Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. If an investing group wants to act more professionally and become confident in their ability to analyze deals, this concise book is a “must read.”
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