Term Sheets: Economic Terms
The economic terms state the price the investor is willing to pay to purchase a certain percentage of ownership in the company, including the preferences, participation rights or mandatory participation in future deals.
Although we refer to a "Series A" financing in this article, 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 in is state 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.
Note: most investors state investment offers in post-money valuation. For example: "We will invest $2 million in your startup at an $8 million valuation." If the investor meant post-money valuation: The company is valued at $6 million today, and she wants to invest $2 million at an $8 million post-money valuation (she wants to purchase 25% ownership). If the investor meant pre-money valuation: The company is valued at $8 million today, and she is offering to invest $2 million at a $10 million post-money valuation (she wants to purchase 20% ownership). The pre-money offer is better for the founder (same amount of investment, but the company is valued higher and a lower percentage of equity is sold). However, the VC likely means post-money.
Price Per Share
The price per share refers to the price that the Series A investors will pay for each share of preferred stock. For calculating investor's rights, the price paid per share 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 number of fully-diluted shares directly prior to the financing (the capitalization explained below).
For example: $6 million pre-money valuation ÷ 8 million shares outstanding = $0.75 per share.
Note: The more shares included in the company's capitalization (the denominator), the lower the price per share of the preferred stock will be (and the more shares/equity the investors will be able to purchase).
Series A investors will expect that the company's capitalization for the purpose of calculating the price per share is "fully diluted" (i.e., all issued and outstanding shares immediately prior to the funding round are included in the calculation). "Fully-diluted" generally includes all issued shares, all options and warrants, and a set percentage of shares reserved and available for issuance to future hires (the employee option pool).
The employee stock option pool (ESOP), also known as the employee incentive pool (EIP), must have enough shares reserved (as authorized but unissued stock) to incentivize future hires. Series A investors usually want the EIP to equals a certain percentage of the fully-diluted capitalization after the Series A round. This means that the EIP usually has to be increased immediately before the Series A round to obtain the desired post-EIP percentage.
In this case, the size of the EIP will be factored into the pre-money valuation of the company so that the existing shareholders will be immediately diluted by the size of the EIP while the Series A preferred holders will not be diluted as those EIP shares are granted to future hires. Because the size of the EIP impacts the company capitalization, the larger the EIP is, the lower the price per share for the Series A preferred stock will be (the VC will get more equity for the same amount of investment). According to Aumni, the average Series A EIP in 2021 was 9.6%.
Note: Best practice is to come prepared with an option plan; list all hires that need to be made before the next financing and an estimated option grant for each. This can be used to negotiate an EIP size that actually makes sense for the company rather than an arbitrary number that investors decide.
Dividends are a sum of money paid by a company to its shareholders out of the company's profits. Dividends can be paid as authorized by the board in its sole discretion, or a class of stock can have a dividend right to be paid at regular intervals (quarterly, annually, etc.). Most investors do not care about dividends because any profits are reinvested into growing the company (creating a bigger exit amount) and cumulative dividends generally don't add much to a large payout. However, Series A investors sometimes require a dividend right with their preferred stock. Even if no dividend is actually paid out, if the preferred shareholders are guaranteed a dividend, it 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.
For smaller investment amounts and lower dividend rates, the dividend is not very significant. e.g.: a Series A investment of $10M with a cumulative dividend rate of 8%. If the exit occurs 5 years after the Series A round, the investors would receive their exit amount, plus 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 seriously impact an exit.
A larger investment amount and a higher dividend rate could have significant consequences. e.g: a Series A investment amount of $30M with a cumulative dividend rate of 10% will accrue $3M worth of interest per year. If the exit was 5 years from the Series A, the investors would be entitled to a dividend payout of $15M.
The dividend rate set by the Series A investors will set the precedent for future funding rounds so that the Series B, Series C and so on will also expect to receive the same rate and will likely invest larger amounts. All of these dividends can add up and the preferred shareholders are paid out before the common shareholders receive anything. Mandatory dividend rights must be included in the company's insolvency analysis. If the preferred shareholder's 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: Private equity investors do care about dividends and will likely require them. This is because dividends matter more where the amount invested is high 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 comes into play in a triggering qualified financing round. The definition of a "qualified financing" is usually determined by the board of directors. The investor must participate in the qualified financing by purchasing at least a pro rata portion of the investor's preferred shares, 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 qualified 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 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 a liquidity event (an exit event, shareholders are cashed out due to a sale of all or a majority of all of the company's assets via a merger, acquisition, or change in control). The preference can be a single (1x) or a multiple (2x, 3x, etc.) of the original investment amount. In a liquidity event, the investors are paid back the preference (plus any accrued and unpaid dividends owed to the preferred shareholders if there is a cumulative dividend as explained above). This amount is paid to the preferred holders before the common holders receive anything (founders and workers usually have common stock). The higher the multiple, the riskier the investor views the startup.
Example: single (1x) non-participating liquidation preference: Total investment amount is first paid to the preferred holders before the common holders are paid anything. This is viewed as fair downside protection for the risk the investor is taking. After the preferred holders are paid out their original investment amount, the founders and other workers (common holders) are paid out of the remaining proceeds. The preferred holders can instead choose to convert their preferred stock into common stock and be paid out of based on their ownership percentage if that payout amount would be larger. For example, if the investor gave $10M for 20% equity and the company is sold for $100M; the investor can choose either: (A) the original $10M investment; or (B) convert into common stock and be paid out on 20% ownership ($100M x 20% = $20M)
Example: multiple (2x) non-participating preference: 2x the total investment amount is first paid to the preferred holders. Then, the common holders are paid out of the remaining proceeds. For example, if the investor gave $10M for 20% equity and the company is sold for $100M; the investor can choose either (A) 2x the original $10M investment ($20M); or (B) convert into common stock and be paid out on 20% ownership ($100M x 20% = $20M). In this scenario, the investor would receive the same amount either way.
There are three 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 (described above).
- Full participation: receives investment back first, and then also shares in the remaining proceeds based on percentage of ownership in the company with the other common shareholders.
- Capped participation: receives investment back first, and then also shares in the remaining proceeds based on ownership percentage, but only until a certain multiple of the original investment amount has been received. Once the multiple is reached, the series of stock stops participating.
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 equally (i.e., they 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 (founders and employees) receive anything. If the company is sold for less than the liquidation preference overhang, the founders will receive nothing unless there is a carve-out for the founders (or a management carve-out for the executives).
The redemption right gives investors the right to repayment of the investment amount at a future date or upon a triggering event (for example, a material adverse change in the company). This right mitigates the risk that the company has not provided the investors a ROI because it is either not successful and therefore an undesirable acquisition target (no exit), or so successful that it can continue operating as an ongoing company without needing to public or be acquired (again, no exit). Without an exit event, the investors will just hold shares in a company for an indefinite period of time. Investors typically want a large ROI, not to a long-term investment).
The investors may also want a redemption right if the investment occurs late in the VC fund's lifecycle (typically 10 years) and there may not be enough time for an exit event to occur. This way, the investors receive their money back before the fund closes and the investment is written off.
Note: VCs will push for redemption rights more when the startup market is risky. A redemption right is a bad signal for future investors and could be viewed as a debt liability and cause issues with existing or future lenders to the company (and could cause the company to be viewed as insolvent). If the redemption right non-negotiable, it should be pushed off as far into the future as possible and should be based on time, not certain events because startups are unpredictable it may be difficult 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, then the conversion price of the existing preferred is simply reduced to the price at which the new shares are issued. e.g: If the Series A preferred stock is $2.00 per share, and stock is later issued at $1.00 per share in the down round; this series' conversion price (into common) will be $1.00 instead of $2.00.
Weighted-Average Anti-Dilution: rather than just reducing the price of the Series A (in the ratchet-based approach), the weighted-average takes the number of shares issued in the lower priced funding round when considering the repricing.
Broad-Based Weighted-Average Anti-Dilution: (most common) the common stock outstanding (including the preferred on as-converted 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.