The process of raising money for entrepreneurs has been demystified in recent years by an increase in the educational resources available. Numerous blogs and podcasts provide founders with materials to assist with their strategic decision-making and to make better-informed decisions.
Despite this increase in transparency, certain aspects of the fundraising process continue to be challenging for founders. In my work as a venture capitalist (VC), I often find that one of the areas where founders struggle the most is when it comes to term sheet negotiation, particularly with regard to certain clauses.
There have been numerous efforts aimed at outlining what a “neutral” term sheet should look like (e.g. Y Combinator’s SAFE Financing Documents and NVCA’s template resources). It’s very important for founders to familiarize themselves with these, because generally, an investor will be the one presenting the first draft term sheet.
To be clear, it is rare to see a term sheet full of aggressive terms that penalize the entrepreneur. A good investor knows that for their investment to succeed, they must have aligned interests with the entrepreneur. A happy and incentivized entrepreneur will ultimately work harder, and because of that, most investors act gracefully and transparently during negotiations.
Nevertheless, there are unfortunately cases where certain term sheet clauses can result in a founder unwittingly losing control or economics in their business. This article highlights potential pitfalls that can arise from this terminology and explains the potential consequences for founders.
N.B. While this article was written primarily with founders in mind, it can also serve as a useful resource for startup employees, who have stock-based compensation.
Before diving into the details of the term sheet clauses, it first makes sense to highlight some of the more basic groundwork that needs to be completed. Below are the areas that I find myself most-often counseling entrepreneurs on when asked for advice.
- Figure out vesting schedules: Internally, before entering negotiations with outside investors, make sure to put in place an appropriate vesting schedule. A sudden departure of a founder with vested stock leaves dead-equity on the cap table, which can have important implications upon the efforts of the remaining founders. Here’s a good guide to get you started on the subject.
- Do your due diligence: With regards to your investor(s), view the process as a two way due-diligence exercise. Their credentials should be assessed beyond how deep their pockets are. Choosing your investors means choosing long-term business partners who play a fundamental role in the development of your business. So make sure to do your homework. Here’s a useful article to get started.
- Be smart about your valuation: Be aware of how your valuation is benchmarked against other companies. A high valuation can certainly show some external validation and stronger paper wealth, and can be used as a good PR weapon. However, it also raises the bar for your performance levels if you want to get to a future round. Here’s a good post on the subject (commonly referred to as the “valuation trap”).
- Get good advice: Finally, in relation to other external parties, contract a lawyer with a track record in this area, and make sure to take your own decision on who to hire. Don’t necessarily choose your investors’ recommendations. This article offers some useful insights into tackling the legal side of things.
Term sheet Details
With the groundwork covered, we can now dive into the details of the most common term sheet clauses that create problems for founders.
Mechanics of Preferred Stock
Early stage investors generally opt for what is called preferred stock for their investments. Preferred stock is a different class (or one could say “family”) of equity from common stock. By having a different stock class, investors are able to add unique terms and conditions that do not apply to other classed shareholders. This can often be seen at IPO time, where voting rights tend to be unevenly distributed across the classes of stock.
Preferred stock sits above common stock in the debtor hierarchy, so holders enjoy the benefit of having their money returned before other stockholders. In a successful exit scenario, this is a forgotten formality, but in a distressed sale, it makes a material difference.
The term sheet clauses detailed in the rest of the article are therefore generally only going to apply to the class of preferred stock that your investors will be creating upon putting money into your company.
One of the most common startup term sheet clauses that you will come across is a liquidation preference. As the name implies, liquidation preferences determine the hierarchy of payout upon a liquidation event, such as a sale of your company. Liquidation preferences therefore allow investors to define the initial magnitude that they are guaranteed as a payout. Let’s look at an example.
A 1x liquidation preference means that investors are guaranteed to get 1x of their initial investment back. So if your investors put $10 million into your company, and the company gets sold for $11 million, they will receive their entire $10 million back before you receive anything.
Continuing on the above, a 2x liquidation preference signifies that they are obliged to receive double their investment. A 3x liquidation preference means they receive triple what they invested, and so on.
Remember that this all occurs before common stockholders (i.e. founders and employees) can begin receiving proceeds. If you accept the inclusion of a liquidation preference, you must adjust your own return expectations to account for this.
The mechanics of how liquidation preferences work are graphically displayed in the charts below.
In each example (the first example being a 1x liquidation preference, and the second example being a 2x liquidation preference), the investor has invested $20 million for a 20 percent post money consideration.
As you can see from the exit values presented on the x-axis, for low value exits, the liquidation preferences give the investor the bulk of the security and relative value, which pulls back returns from common stockholders.
A lawsuit that began from the Epinions and Dealtime merger was instigated by founders and employees of Epinions, who learned that their stock was worthless from the deal, despite their company being merged at a $23 million valuation. This was due to the total value of the liquidation preferences from their investors totaling $45 million, who thus received all stock proceeds from the merger.
If participating preference stock is issued, the investor receives opportunities for further upside after their liquidation rights have been fulfilled. This allows investors to not only reclaim their original investment back via the liquidation rights, but to then share the remaining proceeds on a pro rata basis.
There are three types of participation rights, which range in terms of their economic upside potential to investors. During negotiations, an entrepreneur must pay specific attention to what type is stated.
- Full Participation: The most investor-friendly option. The investor first receives their liquidation preference and then a pro-rata share of any remaining proceeds.
- Capped Participation: As per full, but the total return from liquidation and participation rights is capped at a defined multiple.
- Non-Participating: Most entrepreneur-friendly option. The investor must choose between their straight liquidation preference or a pro-rata share of all proceeds.
The consequences of these terms are that investors can often receive more economic proceeds from an exit than correspond with their actual ownership percentage of the company. Only in successful exits with 1x non-participation would the investor receive proceeds (via electing for their pro-rata) in accordance to their ownership stake.
These clauses are applied by investors as risk mitigants and rewards for showing early faith in a business or during rocky times later on. It is best to be fully aware of the terms agreed upon and to make some test scenarios, to avoid any unpleasant surprises in the future.
The liquidation preference and participation rights will often be included together within the termsheet. Below is a screenshot of the clause in NVCA’s model term sheet template so that you may begin getting accustomed to how it looks. Most term sheets will look similar to do this.
Example: Below you can see an expansion of the scenario that was introduced in the liquidity preference section. In this example, payouts are shown for the different participation rights that the investor could additionally attach to their stock alongside their 1x liquidation preference. Evidently, the full participation scenario results in the highest return profile to the investor. The capped investor follows a similar trajectory, before maxing out at their $40 million cap (2x). For the non-participating investor they first receive their 1x, but after returns of $100 million their payout (and the founder’s returns) will start to correspond with their actual percentage ownership.
In this Q3 2016 report from WSGR, 81 percent of respondents followed non-participation terminology. This dropped slightly for up-rounds, where investors will have responded to higher valuation terms by inserting more protection through capped and full participation rights. In general, a 1x liquidation preference with no participation is a fair offer for an early stage financing round.
Where the liquidation preference becomes interesting is in future rounds, in which new investors negotiate their seniority versus the older investors.
As the quoted report shows, 41 percent of respondents inserted higher seniority, compared to 54 percent opting for pari-passu (equal) against older shareholders. These figures are almost the inverse for funding in down rounds (53 percent vs 33 percent respectively).
A rational investor always enters into a deal because they believe that it will become a home run success. Despite this mentality, they will often look to put contingencies in place to secure their ownership stakes in the event of disappointing future outcomes.
This is particularly pertinent in down round (lower future valuation) scenarios. At this crossroad, a lower future valuation of their stock will not only harm their economic interests, but could also dilute their ownership stake and thus reduce their strategic influence over the company.
To mitigate lower future valuations, investors can insert anti-dilution clauses that act to readjust their ownership stake to avoid receiving too hard a hit. The main applications of this are via the weighted average and full ratchet methodology. You could visualize these as insurance policies for investors to protect them against down rounds, in the same way that put options would be applied in portfolio management.
Both methods involve converting the holders’ existing stock into a new allocation to account and compensate for the effects of a down round. The difference between the two is that weighted average dilution accounts for both price and the magnitude of the new issuance against the existing capital base. Full Ratchet just accounts for the effect of the new price.
By contemplating the magnitude of the new round, the weighted average method is more founder friendly. This article provides clear explanations, if you wish to learn more about the calculations behind these methods.
These days, a full ratchet can be a rare sight within early-stage investing term sheets. They are seen an extreme way of applying investor protection, because their application can actually result in investors increasing their ownership percentage once they are triggered. This is because a Full Ratchet will trigger a repricing of all the clause-holders’ shares, even if just one new share is priced at a value below theirs.
To demonstrate a comparison of the effects of each of these methods, a visual summary of their resulting ownership percentage changes can be seen below. In these examples, Series A investors have either held no anti-dilution protection or full ratchet/weighted average clauses and have just faced a Series B down round. Notice how in the Full Ratchet example, the Series A investor ends up with a higher percentage share in the company.
Note: Series A investors invested $20 million at a $80 million pre-money Series A valuation. The proceeding Series B round investor invests $30 million at a $60 million pre-money.
The WSGR report referenced above shows that the overwhelming majority of investors are now opting for the more egalitarian, broad-based weighted average method.
If dilution protection is being negotiated, unless your company is in a very distressed financial situation, you should strongly argue for broad-based, weighted average dilution coverage.
Real Example: In 2016, following a discovery of its light regulatory practices, Zenefits retroactively revalued its previous investment round (from $4.5 billion to $2 billion). This resulted in its series C investors increasing their ownership from 11 percent to 25 percent. To offset the effects of this dilution, previous investors received small adjustments, and common stockholders (diluted by 20 percent) were granted 12-month vesting stock grants.