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Startup 101 - Lesson 2: Understanding Term Sheets

In this series, I will be posting articles on Venture Financing, and in particular, how as a startup founder you will navigate the landscape. The posts will be a concicse summary of the book that inspires me, Venture Deals by Brad Feld which is the best-seller on startups and entrepreneurship. The authors are venture capitalists, and give you the insight on how venture firms think.

In the first post, I will outline the various players in a venture deal. In this installment, I will go through understanding Term Sheets.

The Term Sheet

Term sheets are critical and more than just a letter of intent, but rather form what will be the final deal structure, a blueprint of the relationship between the startup and future investors.

For investors, term sheets allow them to exercise control over business or veto certain decisions the company can make.

Pricing & Valuation

When working out the valuation of a company, you determine that by multiplying the number of outstanding shares by the price per share. This is typically represented on a term sheet, either in terms of price or amount of financing, as cited in Venture Deals by Brad Feld:

Price: $__ per share. This is the original purchase price (fully diluted premoney valuation) of $....... million and fully diluted post-money valuation of $......... mullion. Fully diluted assumes conversion of all outstanding preferred stock as well as exercise of all authorized and currently existign stock options and warrants, and increase of company's existing option pool by a certain number of shares prior to financing.

Amount of Financing: An aggregate of $..... million, representing .... % ownership on a fully diluted basis, including shares received reserved for employee options in pool. At closing, company will reserve shares of common stock so that .....% of its fully diluted capital stock following issuance of Series A Preferred Stock is avaliable for future issuances to directors, officers, employees and consultants.

Price is usually referred to as valuation and its important to understand the two different ways in which valuation is discussed, pre-money which is what the investor valuates the compay at today prior to investment, whilst post-money is premoney valuation plus contemplated aggregate investment amount.

This is a a genuine trap that VCs sometime set for entrepreneurs and worth understanding: When an investors says I'll invest $5m at valuation of $20m it usually means post-money which means $5m will buy 25% of a $20m post-money company. If the investor explicitly says I'll invest $5m at a premoney evaluation of $20m it would only buy $20 percent of the $25m postmoney evaluation. It is always best to not assume and clarify what the investor means, as it shows you are on the ball. (source: Venture Deals by Brad Feld )

Dilution

"Upon creation of company, founders receive common stock whereas VCs purchase equity and thus receive preferred stock".

It is important that there is sufficient equity (stock options) to compensate it's startup team, known as the employee/option pool, which should not be too big but sized appropriately to not look like the company will run out of available employee options. This is why the pool size is taken into account during valuation of the company, effectively lowering the actual premoney valuation, which isn't good, according to Felds.

Going back to the example Felds gave, a $5m investment in a $20m premoney (for total of $25m), you would have an existing option pool of options representing 10% of outstanding stock reserved/unissued. Let's say the VCs suggest they want a 20% option pool, and you would have to take the extra 10% out of the premoney evaluation, reducing your premoney evaluation to $18m.

It is common to have an option pool range of between 10 and 20 percent, and VCs will try to have the increase prior to financing, so founders can either try and negotiate a more favorable reduced amount, or negotiate on a premoney evaluation and ask for an increase in investment to make up the valuation shortfall, or request that the increase in option pool gets added to the deal post-money.

Warrants and Bridge Loans (Convertible Debt)

You will see the term warrants in Term sheets, and another way for investors to try and devaluate your company. Like a stock option, warrants, like police warrants is a right given, to purchase a* set number of shares at a predefined price* for a specific period of years, prior to expiration, like a 10-year-warrant for 100,000 shares of Series A stock at $1 per share, irrespective of what the price of the share is during that decade. This is quite a complex topic that ads overhead and Felds would recommend trying to negotiate for a lower premoney valuation rather than accept warrants.

Brige Loan is something that is mentioned in financing as well and is coupled with warrants, occurs when an investor that is planning to invest is waiting for additional investors to participate, will instead make the investment a convertible debt which will convert into equity at the price of the upcoming financing. The bridge loan investor takes additional risks and would therefore get a discount on the price of equity, up to 20 percent, or receive warrants that grant a discount of up to 20%.

How are companies valuated?

This isn't an exact science according to Felds, but rather takes into account various factors, some of which are quantifiable and others qualitative. Some of the factors include:- * Stage of the company (early stage in which tend its more determined by experience of entrepreneurs and amount of money raised or the more developed startups in which case historical financial performances and future projections impact) * Competition with other funding sources (the more competition the higher you will be valued at)

Liquidation Preference

This impacts how the proceeds are shared in a liqudity event, whether it would be through sale of company/majority of assets, and the order of liquidity is important, especially when the company is sold for less than the maount of capital invested. There are two components of liquidation preferences, actual preference and participation preference.

In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock, a per share amount equal to X (times) the Original Purchase Price plus any declared but unpaid dividends . Traditionally the standard was for 1X liquidation preferences but that has gone up to up to 10X during the internet bubble, but it has clawed its way back down to 1X these days. (source: Venture Deals by Brad Feld)

It's important to consider whether investor shares are participating (whether it is full participation, capped participation or no participation). Full participation stock receives participation amount and then share in liquidation proceeds on as-converted basis (if stock were converted into common stock based on conversation ration). When it is capped participation, the liquidtation will proceed on as-converted basis until a certain multiple return is reached (original purchased price).

Liquidation gets more complicated when we are not dealing with just Series A term sheets but when dealing with multiple series, and deciding the liquidation order between various series, and outside the scope of this article.

This certainly warrants a separate article and if I have time, I can provide some research into that.

Pay-to-Play

An interesting provision relevant in a down round financing, and useful when the founders are struggling to get their financial round goals met. Investors are required in this provision to keep investing and participate prorate in future financing in order to not have their preferred stock converted into common stock.

Vesting

Stock vesting means that you have to wait for a predefined period of time in order to own all of the stock options set aside for you, and if an employee leaves the company before the end of the four-year period, vesting formula applies and a percentage of stock is received. General standards dictate that early stage companies provide a one-year cliff and monthly vesting thereafter.

If someone leaves with stock still left unvested, it goes back into the pool whereby everyone benefits (VCs, stockholders) in what is called reverse-dilution (if its founders stock it just vanishes).

The topic of what happens to vesting options during a merger or liquidation is beyond the scope of this article but certainly worth a read. I would suggest looking at chapter 3 of Felds, which talks about Single-trigger acceleration and Double-trigger acceleration.

Antidilution

The final aspect of the Term sheets worth noting is antidilution, a clause that protects investors in the event a company issues equity at a lower valuation than in previous financing, and can be based on weighted average antidilution or ratchet-based anti-dilution. What this generally means is that if a company does issue shares at a lower price, investors benefit from having their earlier round price effectively lowered to the price of the new issuance. This is another big topic onto itself and worth reading, but at least you now know a bit about

Summary

I found the second and third chapters of Venture Deals by Brad Feld served me well in referencing the different players on the startup scene, how to look and treat each of the players, and what to look out for.

In the next installment, I will go further into Term sheets before diving into the Capitalization table.