Term Sheets: Economic Terms
The economic terms of the deal include the investment amount, the percentage of the company being sold, dividend and redemption rights (if any), any guaranteed exit multiple, and voluntary rights or mandatory participation in future deals.
Although a "Series A" financing is referred to, the same terms can apply to any priced round in which a newly created class of preferred stock is sold to investors (whatever you decide to call it).
Valuation refers to the value of the company and is stated in either "pre-money" or "post-money" terms.
Pre-money valuation is simply the current value of the company before the deal.
Post-money valuation value of the company before the deal, plus the total new money coming in.
Investors typically state offers in post-money terms. For example: "We will invest $2 million at an $8 million valuation." If the investor meant post-money valuation: the current value is $6M, and the investor will give $2M at an $8M post-money valuation (purchase 25% ownership). If the investor meant pre-money valuation: the current value is $8M, and the investor will give $2M at a $10M post-money valuation (purchase 20% ownership). The pre-money offer is better for the founder - same investment amount, but the company is valued higher and a lower percentage is sold). However, the VC likely means post-money.
Price Per Share
The price per share refers to the price that the investors will pay for each share of preferred stock. For calculating investor's rights in the future, this is referred to as the "Original Purchase Price" in the financing documents. The price per share is determined by dividing the pre-money valuation of the company by the company capitalization (explained below).
For example: $6M pre-money valuation ÷ 8M company capitalization = $0.75 per share.
The more shares included in the company's capitalization (the denominator), the lower the price per share will be (and the more shares/equity percentage the investors money will purchase).
Series A investors will expect that the company's capitalization for the purpose of calculating the price per share is "fully diluted." This means that all issued and outstanding shares immediately prior to the funding round are included in the calculation (including all outstanding options and warrants). The investors also typically require the company to have a certain percentage of shares reserved and available for issuance in the employee equity pool which may need to be increased directly before the investment round.
The stock option pool, or "equity incentive pool" (EIP), must have enough shares reserved (as authorized but unissued stock) to incentivize future hires. Series A investors usually want the EIP at a certain percentage post-closing. This often means that the EIP has to be increased immediately before the Series A round to obtain the desired post-closing EIP percentage.
The shares in the EIP (including any increase) are included in company capitalization. This means that the existing shareholders will be immediately diluted by the shares in the EIP and the Series A preferred holders will not be diluted as those EIP shares are granted to future hires. Because the size of the EIP is included in the company capitalization, the larger the EIP, the lower the price per share for the Series A preferred stock will be. According to Aumni, the average Series A EIP in 2021 was 9.6%.
Use a well thought out hiring plan with a list of all hires before the next financing to negotiate an EIP size rather than an arbitrary percentage decided by investors.
Dividends are profits paid to shareholders. Dividends are usually only paid if authorized by the board of directors (in its sole discretion) and startups rarely ever offer dividends because all profits are reinvested to R&D and to scale the company (creating a bigger exit valuation).
But, the Series A preferred stock can have a dividend right to be paid at regular intervals (quarterly, annually, etc.). Most investors do not care about dividends (they'd rather have a bigger exit payout) and cumulative dividends generally don't add much to a large payout. That said, Series A investors sometimes require a dividend right with their preferred stock. Even if no dividend is paid out, the dividend amount may accrue and be added to the total payout owed to those shareholders in a liquidation event.
According to Aumni, 99.5% of Series A rounds in 2021 had a dividend rate of 8% or less. As the startup market becomes more investor-friendly and interest rates increase, investors may negotiate special dividend rights.
Dividend are not very significant for smaller investment amounts. For an investment of $10M with a cumulative dividend rate of 8% and an exit after 5 years, the investors would receive an additional $4M in dividends ($10M x *8% = $800K per year x 5 years = $4M). $4M is a large amount of money, but generally not enough to significantly impact a large exit.
Dividends can become significant for larger investment amounts For an investment of $30M with a cumulative dividend rate of 10%, $3M will accrue per year. If the exit is 5 years from the investment, the investors would be entitled to a dividend payout of $15M.
The dividend rate set by the Series A investors will also set the precedent for future funding rounds so the Series B, Series C and so on will expect to receive the same rate. Because those later rounds will be larger amounts, the dividend amounts can add up. Remember that the investors are entitled to be paid out the cumulative dividend along with their liquidation preference amount before the common shareholders receive anything.
Additionally, mandatory dividend rights must be included in the company's insolvency analysis. If the dividend rights exceed the cash coming into the company, the company could technically be in the zone of insolvency which could negatively impact its ability to open new lines of credit or enter into leases and could create issues with existing creditors.
Note: PE investors do care about dividends and will likely require them. This is because dividends matter more where the investment is large and the expected ROI is low. Here, the dividend basically serves as interest on the investment amount.
Note: Dividends can also be paid in stock rather than cash. Founders should be aware that investors may try to use this method as an additional form of anti-dilution protection.
The pay-to-play provision requires the investor to participate in a future financing rounds by purchasing at least a pro rata portion of the investor's current equity, otherwise, the investor's preferred stock will be converted into common stock.
In less severe cases, the VC can partially participate and will only lose the portion of the preferred shares equal to the amount that the investor didn't invest in the round. If a follow-on lead investor doesn't want to share the deal (give earlier investors the opportunity to invest in that round), the play-to-play requirement can be waived.
This provision generally benefits the company; follow-on investment is guaranteed or the VC's liquidation preferences are reduced. Thus, only investors who are committed to the company continue to retain the economic rights and control features of preferred stock. According to Aumni, only 4.5% of Series A financings in 2021 had a play-to-play provision.
Note: founders should negotiate for the pay-to-play unless the investor generally does not participate in subsequent round (e.g., Angel investors, friends and family).
The liquidation preference determines how proceeds are distributed in an exit event. The single preference of 1x the original investment amount is the most common and is generally viewed as fair downside protection for the risk. The higher the preference multiple, the riskier the investor views the startup. The preference amount is paid to the investors before the common shareholders (founders and workers) receive anything. The investors can instead choose to convert their preferred stock into common stock for a pay out based on their equity percentage if that payout amount would be larger.
1x non-participating preference: The investment is repaid to investors, and then the common shareholders are paid their pro rata amount of the remaining proceeds. If an investor currently owns 20% equity on a $10M investment and the company is sold for $100M - the investor can choose either: (A) $10M; or (B) convert into common and be paid $20M for 20% ownership ($100M x 20% = $20M).
2x non-participating preference: 2x the investment is repaid to investors, then, the common shareholders are paid their pro rata amount of the remaining proceeds. If an investor currently owns 20% equity on a $10M investment and the company is sold for $100M - the investor can choose either: (A) $20M ($10M x 2 = $20M); or (B) convert into common and be paid out $20M on 20% ownership ($100M x 20% = $20M). The investor would receive the same amount either way.
There are 3 types of liquidation preferences:
- No participation: ("nonparticipating preferred" or "simple preferred") receives only its liquidation preference and doesn't participate in the distribution of the remaining liquidation proceeds. Alternatively can convert into common if that is a bigger payout (described above).
- Full participation: receives investment back first, and then also shares in the pro rata split of the remaining proceeds with the common shareholders based on an as-converted to common basis.
- Capped participation: receives investment back first, and then also shares in the remaining proceeds based on an as-converted to common basis, but only up to a certain multiple of the original investment.
Follow-on investors will either chose a "stacked preference" or a "blended preference."
Stacked Preference/Standard Seniority: (most common) the most recent investors stack their preferences on top of the previous ones (e.g., Series C will take its preference first; then Series B; then Series A). If the company sells for an amount that equals or is less than the last Series' preference amount, that series will receive the full proceeds of the liquidation and no other series (or common) will be receive anything.
Blended Preference/Pari Passu: (means "side-by-side" in Latin), all of the series of preferred shares receive their preferences equally (i.e., share pro-ratably until all preferences are received)
The "liquidation preference overhang" is the amount of money that is needed in a liquidity event to pay all the liquidation preferences before the common stock receive anything. If the company is sold for less than the liquidation preference overhang, the founders and workers will receive nothing unless there is a carve-out for the founders (or the existing executives).
The redemption right is a right to repayment of the investment amount at a future date or upon a triggering event (e.g., a material adverse change in the company). This right mitigates the risk that the company will not provide the investor a return because it is either not successful and not a desirable acquisition target (no exit), or it is so successful that it can continue operating as an ongoing company without needing to go public or be acquired (again, no liquidity or exit). Without an exit event, the investors will just hold shares in the company for indefinitely and investors desire a large ROI, not to a long-term investment.
The investors may also want a redemption right if the investment occurs late in the fund's lifecycle (typically 10 years) and there will likely not be enough time for an exit event to occur. This way, the investors receive their money back before the fund closes and the transaction is written off as a bad investment.
Note: VCs may push for redemption rights when the startup market is risky. The right is a bad signal for future investors and may be viewed as a debt liability which could cause issues with existing or future lenders (the company is viewed as insolvent). If a redemption right non-negotiable, it should at least be pushed off as far into the future as possible and should be based on time, not events because startups are unpredictable it may need to pivot without triggering the redemption right.
Anti-dilution provisions protect investors when a subsequent financing is valued lower than the current round (a down round). These protections are almost always included on the term sheet (nonnegotiable) and will be either ratchet-based anti-dilution or weighted-average anti-dilution (negotiable).
Full Ratchet-Anti-Dilution: if the company issues shares at a lower price in the future, the as-converted to common price of the existing preferred is simply reduced to the same price as the new shares. e.g: the Series A preferred stock is $2 per share, and stock is later issued at $1 per share; this Series A conversion price (into common) will be $1 instead of $2.
Weighted-Average Anti-Dilution: rather than just reducing the price of the Series A (in the ratchet-based approach), the weighted-average takes into account the number of shares issued in the lower priced round when considering the repricing.
Broad-Based Weighted-Average Anti-Dilution: (most common) the common stock outstanding (including all preferred on as-converted to common basis) and all stock that could be obtained (options, warrants, etc.) are included in the calculation.
Narrow-Based Weighted-Average Anti-Dilution: only current outstanding stock is used in the calculation.
Note: Some VCs will tie anti-dilution provisions to company milestones. If presented this, consider that startups often pivot and pre-determined goals may no longer align with the company's evolving vision. A startup should be flexible and agile, not tied to past objectives prescribed by an investment series.