16 Feb

Decoding the term sheet

Lawyer: “What was Mr. Zuckerberg’s ownership share diluted down to?”

Eduardo: “It wasn’t.”

Lawyer: “What was Mr. Moskovitz’s ownership share diluted down to?”

Eduardo: “It wasn’t.”

Lawyer: “What was Sean Parker’s ownership share diluted down to?”

Eduardo: “It wasn’t.”

Lawyer: “What was Peter Thiel’s ownership share diluted down to?”

Eduardo: “It wasn’t.”

Lawyer: “And what was your ownership share diluted down to?”

Eduardo: “0.03%”

When Eduardo Saverin discovered that Mark Zuckerberg had issued new shares in Facebook without telling him, he wasn’t too happy about it. And understandably: He had been diluted by a factor of ~1000x. At today’s Facebook valuation, he had lost around $44bn dollars. While it’s unlikely this is going to happen to you (Eduardo was diluted via unusual tactics from Zuckerberg), it should remind you that it’s important to pay attention to the legal docs when it comes time to raise money!

The clauses in a term sheet are divided into two key categories: Economic and Control terms. The Economic terms are those which most directly impact the valuation of the company and the potential return shareholders will receive upon an exit. Control terms encompass those which empower or limit the actions of investors with regards to major decisions that arise during your company’s lifespan.

In this article, we outline the important concepts that arise in each bucket, decode the legalese, and give you a good benchmark for what’s standard in a Seed round term sheet.

Some of the ‘standard term’ quotes were taken from the documents available from Techstars and Series Seed.

KEY ECONOMIC TERMS

1. Price


Sample term sheet language:

“The financing will be up to an aggregate of $1,000,000 in newly issued Seed preferred at a fully diluted pre money valuation of $5,000,000, including an available option pool equal to 20% of the post money fully diluted capitalization”

Explanation:

This is the single most important term on the term sheet.  It tells you how much your company is worth, and how much of it you are giving away to the investor. Let’s explain the important terms one by one.

Seed Preferred”: The new class of shares that your company will be issuing upon completion of the financing round. Before a financing round, the only stock in existence is likely to be common stock (assuming you have authorized any shares at all). In almost all cases, VC’s exclusively invest in preferred shares. Preferred shares are senior to common shares. That is, in the event of liquidation, preferred shareholders receive available funds before common shareholders. They also have a whole list of rights and protections attached to them which common shares do not. All of these are outlined in the term sheet.

Pre money”- please refer to our article on equity vs. debt for an explanation of this term.

Option pool”: Common stock set aside for employees and advisors awarded in the form of options. Options are rights to buy shares which ‘vest’ (become due) over a specified period. For example, let’s say you award an employee 20,000 options which vest 25% one year following the award, and then vest monthly for the next three years (an industry standard vesting schedule). In your cap table, you will demarcate 20,000 common shares from your option pool for that employee. At the end of the employee’s first year, she will be able to purchase 5,000 shares. Thereafter, every month, he will be able to purchase an additional c.417 (15,000 / 36 months) shares. She will be able to purchase the shares at the ‘strike price’, which is set via a valuation of common stock performed by an independent party (a “409A” valuation).

Typically, the option pool is equivalent to c.15-20% of the post money valuation. In the example above, it is $1.2m (20% * ($5m pre money + $1m investment)).

Investors will often include this option pool in the pre-money valuation (as they have done in our example above). Watch out for this – it is a common stumbling block for entrepreneurs. Although the pre-money is listed as $5m, the effective pre money is actually $3.8m ($5m pre money – $1.2m option pool).

Fully diluted valuation” refers to the valuation assuming the exercise of all convertible securities. In our case above, this entails including the effects of conversion of the options.

Let’s illustrate how all of this works visually.  Assume our example company has three founders. Prior to the financing, Founder 1 owns 40%, Founder 2 owns 35% and Founder 3 owns 25%. Only common stock exists. So the equity split looks like this ( [c] refers to common stock, [p] refers to preferred):

Following the $1m seed round, and the addition of the option pool, the split looks like this:

          

Because the raise entails the issuance of new preferred shares and the addition of the option pool, each founder’s stake is diluted on a percentage basis. The absolute value of their stake, however, has increased.

What’s standard?

For seed stage tech companies, the average pre money valuation is around $5m, and option pools are typically 10-20%. You should expect VCs to put the option pool into the pre-money. There are a variety of ways to negotiate against it, but at Seed stage you shouldn’t worry too much about it as long as you are broadly happy on price and ownership.

2. Liquidation preference


Sample term sheet language:


“One times the Original Issue Price plus declared but unpaid dividends on each share of Series Seed, balance of proceeds paid to Common.  A merger, reorganization or similar transaction will be treated as a liquidation”

 

Explanation:

There are two components to a liquidation preference: The preference and the participation:

  1. Preference: In the event of a liquidation, the amount returned to the holders of preferred stock before the common stockholders are paid out. This is typically expressed as a multiple of the original investment (1x, 2x). For example, if a VC invested $1m at a 2x liquidation preference, he will get paid $2m in the event of a liquidation. There are a whole host of potential complexities and scenarios where this wouldn’t be the case, but we’ll keep it simple here.

 

  1. Participation: The degree to which preferred holders share in the proceeds after the liquidation preference has been paid out:

    • ‘Non-participating’: After the preference is paid out, preferred holders receive nothing more. In the case of a sale for a decent price,  where the common will receive more than the preferred, VCs will typically forgo the preference and convert their stock to common. The liquidation preference in the sample language above is non-participating. This is the most founder friendly
    • ‘Fully participating’: VCs receive their preference, and also share ratably with the common in the remaining proceeds. This is the most VC friendly
    • ‘Capped participating’: This is a compromise between non participating and fully participating. VC’s receive their preference, and share ratably with the common in the remaining proceeds until the proceeds to the VC (including the preference) reaches a certain multiple. Remaining proceeds then go to the common

What’s standard?

Most seed deals these days are done at a 1x liquidation preference and non-participating preferred (85% of seed deals in 2012 according to Fenwick and West’s 2012 seed financing survey). Seed liquidation preference (both the preference and the participation) has become much more entrepreneur-friendly over time

3. Founder vesting


Sample term sheet language:


“Shares held by the Founders will be subject to reverse vesting provisions as follows: 40% shall be vested at Closing, with the remaining 60% to vest in equal monthly installments over the four years following Closing. There shall be single trigger acceleration on a Change of Control for 25% of unvested shares and the remaining 75% of unvested shares shall accelerate upon double trigger”

 

Explanation:

We explained the concept of vesting earlier during our discussion of employee option pools. Founder vesting is when VCs stipulate that a founder’s common stock vests over a specified time period. This is in order to incentivize the founder to remain at the company and, if he leaves soon after funding, doesn’t do so with a large chunk of equity.

‘Reverse vesting’ is when a vesting schedule is applied to stock that a founder already owns going into the funding round.

 

Under ‘Single trigger acceleration’, if there is a change of control (e.g. an acquisition of the company), all equity subject to the single trigger vests immediately. Under ‘Double trigger acceleration’, equity accelerates if there is a change of control AND the employee is subsequently fired from the acquiring company.

What’s standard?

4 year vesting for founders is standard, and often a good idea. It takes time to build a big company, especially a company big enough to provide a meaningful return for all parties once the company has taken VC money. Reverse vesting is also common. Double trigger acceleration is market for seed deals.

KEY CONTROL TERMS

1. Board of directors


Sample term sheet language:

“Two directors elected by holders of a majority of common stock, one elected by holders of a majority of Series Seed. The lead investor shall have the right to appoint a non-voting observer to the Board”


Explanation:

Upon signing of the term sheet, your Board will be comprised of the individuals outlined in this clause. In this case, it will be three members: two elected by a majority of the common stockholders (i.e. founders), and one elected by the majority of the preferred (i.e. VCs). The lead investor can also appoint a non-voting observer, i.e. somebody who can participate in the discussions, but doesn’t actually actually vote.

You will need board approval for almost all of the most important activities within your company (e.g. raising more money, selling the business). More importantly, the board (if well-assembled) is a valuable group of consiglieri who will help you navigate through the early days of your business.

What’s standard?

VC’s will ask for board seats. You should attempt to retain control at seed stage (e.g. 2 people elected by common stock, 1 by preferred). As you raise subsequent rounds, expect to gradually lose control. Also remember that you should invest time into assembling  a board who will be able to add real value, e.g. fellow entrepreneurs who have been successful in and understand your industry. At seed stage, as long as you retain a majority, you should be more concerned with assembling a value-added board than percentage control.

One caveat: while at first glance the non-voting observer may not seem that important (because he can’t vote), in practice, outcomes of major decisions are decided during board conversations, prior to votes being cast. Hence a vocal observer, can heavily influence voting even though he can’t actually vote.

2. Important decisions (a.k.a. protective provisions / voting rights)


Sample term sheet language:

“Certain important actions of the Company shall require the consent of the holders of a majority of the Outstanding Seed preferred (a “Seed preferred Majority”), involving any action to (a) alter the rights, preferences or privileges of the Seed Preferred (b) allot any new shares beyond the shares anticipated by this investment (c) create any new class or series of shares having rights, preferences of privileges senior to or on a parity with the Seed Preferred (d) increase the number of shares reserved for issuance to employees and consultants, whether under the ESOP or otherwise (e) redeem any shares of the company (other than at cost in connection with a right of repurchase) (f) pay or declare dividends or distribution to any holders of securities (g) increase or decrease the authorised number of board members (h) take any action which results in a Change of Control of the Company (i) subscribe or otherwise acquire or dispose of any shares in the capital of any other company and(j) amend the Company’s Certificate of Incorporation in a manner adverse to the Series Seed stock.”


Explanation:

These provisions allow the investor to veto actions of the company which might impact his dilution and/or ultimate return. The above sample stipulates that the following actions require the investor’s approval:

  1. A change of the rights attached to the VC’s stock

  2. Issuance of new equity

  3. Creation of a new class of equity that has the same or greater rights as this round’s new preferred equity

  4. Increase of option pool

  5. Repurchase of stock

  6. Payment of dividends or any capital distribution to stockholders

  7. A change in the permitted number of board members

  8. Sale of the company

  9. Acquisition or sale of another company

  10. A change to the Certificate of incorporation in a manner that disadvantages the investor


What’s standard?

All the terms above are standard protective provisions. These are not a place to negotiate unless you get thrown a serious curveball.

3.Participation right / pre-emption right


Sample term sheet language:

“Major investors will have the right to participate on a pro rata basis in subsequent issuances of equity securities”


Explanation:

Allows current investors to invest in future financing rounds, in an amount equal to their % ownership of the company. Remember that each financing round typically involves the issuance of new shares, which reduces all existing shareholders’ stakes (a.k.a. dilution). If a Series Seed investor owns 10% of the company after a seed round, this clauses enables him to participate in up to 10% of the Series A financing.

What’s standard?

A clause like this is standard. That is, unless an investor wants supra pro rata rights, which you should fight against. We go into more detail on this in Chapter 5 of The Secret of Raising Money.

4. Drag-along agreement


Sample term sheet language:

“In the event that a Seed Preferred Majority and the holders of a majority of the Common Stock wishes to accept an offer to sell all of their shares to a third party, or consent in their capacity as shareholders to enter into a merger, asset purchase, or other Change of Control event of the Company, then subject to the approval of the Board, all other shareholders shall be required to sell their shares or to consent to the transaction on the same terms and conditions, subject to the liquidation preferences of the Seed Preferred”

Explanation:

Once a majority of investors and a majority of common stockholders agree to a sale of the business, all other shareholders must also sell their shares, regardless of whether they agree with the deal or not (the remainder is ‘dragged along’ with the majority)

What’s standard?

A drag along agreement like this one is standard. This kind of clause only really becomes relevant in exit scenarios with poor outcomes.

5. Conversion


Sample term sheet language

“Each holder of the Seed Preferred shall have the right to convert its shares at any time into Common Stock. The initial conversion rate shall be 1:1, subject to proportional adjustment for stock splits, stock dividends, recapitalizations and similar events”


Explanation:

This enables VC’s to convert their preferred equity into common stock. This typically happens in sale scenarios when common stockholders get a better deal than the preferred holders (the case in pretty much every good outcome, assuming a 1x preference), and investors have a non-participating liquidation preference.

What’s standard?

A conversion clause like this one is standard in any VC term sheet. Without a conversion clause, VC’s would be unable to generate a meaningful return in a deal with a non-participating liquidation preference.

6. Exclusivity


Sample term sheet language:

“For a period of thirty days, the Company agrees not to solicit offers from other parties for any financing.  Without the consent of Investors, the Company will not disclose these terms to anyone other than officers, directors, key service providers, and other potential Investors in this financing”

Explanation:

Stipulates that once you have signed this term sheet, you can’t shop around for other investors during the specified time period (in the above case, 30 days)

What’s standard?

An exclusivity period is normal and necessary in term sheets from potential lead investors. At some point, you have to stop playing games with each other and ink a deal. Time period should be no longer than 60 days.

A NOTE ON CONVERTIBLE DEBT

This article applies to equity term sheets. For your convenience, here’s a breakdown of the three most important terms in a convertible note, and the market standard for each. For our more detailed explanation of the mechanics and terminology related to convertible debt, please read our article on debt vs. equity.

1. Valuation cap and discount rate


Sample language:

“If the Company issues equity securities in a transaction or series of related transactions resulting in aggregate gross proceeds to the Company of at least $5,000,000 including conversion of the Notes and any other indebtedness (a “Qualified Financing”), then the Notes, and any accrued but unpaid interest thereon, will automatically convert into the equity securities issued pursuant to the Qualified Financing at a conversion price equal to the lesser of (i) 80% of the per share price paid by the purchasers of such equity securities in the Qualified Financing or (ii) the price equal to the quotient of $5m divided by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing”


Explanation:

This mouthful of text says the following: Assuming the company raises $5m or more in its next funding round, the convertible note will convert at whichever of the following is less: (i) A 20% discount to the price of the round or (ii) A $5m valuation. In more common parlance – the note has a 20% discount and a $5m valuation cap. Again, we go into more detail about how convertible notes work, and the rationale behind each term in this article.


What’s standard?

The vast majority of seed stage notes have a cap and a discount. The average cap is around $6m, and the average discount rate is 20%.

2. Interest rate


Sample language:

“Simple interest will accrue on an annual basis at the rate of 6% per annum based on a 365 day year”


Explanation:

Interest accrues annually, and is calculated using only the note principal (simple) rather than the note principal+accrued interest (compounding). Remember – this is not like other types of debt where interest is actually paid out monthly or quarterly. The vast majority of early stage companies are not sufficiently cash generative to take on such obligations (that is, if they generate any cash at all). Interest is paid out only when the note converts at the next round, or matures (if you don’t raise another round and the noteholders don’t opt for a conversion to equity)


What’s standard?

5-6% simple interest

Conclusion

There are a ton of other terms that will crop up on term sheets. We opted to focus on the ones that will most heavily impact your business.

A final word of warning: If your business is successful, it will never be because you out-negotiated the VC’s in your seed round. So your goal here should be to raise money on standard terms and get back to building your product. It’s still important that you understand the clauses in your term sheet: Firstly, it’s very possible that you get f**ked by inexperienced or sneaky investors who put in some entrepreneur-unfriendly clauses. Secondly, as you raise subsequent rounds of financing, these terms become far more material to your ultimate outcome and hence you will need to spend more and more time negotiating them.

With The Secret of Raising Money, we provide a comprehensive review of every term you need to understand on your term sheet, give you an easy to use cap table AND a sheet you can hand out to your employees so they understand the basic building blocks of the financing that effect them.

N.B. – These benchmarks are based on  Silicon Valley. 

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  • michaelgsimpson

    Testing