As a follow on to CEO’s article on Venture Capital and Limited Partnerships, we’ve decided to transition to the intersection of VCs and start ups – the term sheet.
Term sheets are the point at which start-ups and VCs meet and are designed to quantify and qualify the proposed relationship. Partnering with a VC firm is an exciting prospect for many entrepreneurs as it represents the beginning of a new chapter for their business. Equally, VCs, after having reviewed hundreds of start-ups, are eager to put their capital to work and want to help the entrepreneur realise his or her full potential. That said, term sheets should be reviewed with care. Decisions made during these negotiations can have far reaching consequences relating to the founder’s control and potential future economic benefit. As term sheets range in their complexity, the aim of this article is to explore and define some of the terms entrepreneurs may encounter when negotiating with VCs.
It is important to remember that the relationship between the VC and start up is a two-way street - VCs have the responsibility of serving the interests of their Limited Partners while start-ups need financing to continue to grow. With this framework in mind, let’s explore some of the common and not-so-common terms.
Valuation – The “pre-money” valuation and “post-money” valuation are common terms thrown around in the VC lexicon. Put simply, pre-money is a measure of the market value of the company before it receives the invested capital while post-money equals the pre-money valuation plus any new capital invested. This is a cornerstone negotiation point as valuation determines the VCs equity stake and can set the stage for further terms that the VC may use to “readjust” what it may deem as an unfair valuation.
Redemption Rights – This clause protects VC investors by requiring that the start-up repurchase the shares after a specified period. Redemption rights allow investors to exit a stagnant start-up before a liquidity event.
Dividends - While start-ups don’t normally pay dividends (distribution of company profits to shareholders), VCs may include a dividend provision in the term sheet as a protective measure. This provision, if cumulative, carries the dividend forward until it is paid, often at the time of the exit. Thus, a cumulative dividend provision allows investors to guarantee a minimum return on their investment.
Liquidation Preference – In the event that the company has a liquidity event, this term dictates how the VC will be paid. This term also protects the investor if the company does not perform well. In this case, the VC’s investment takes on the appearance of a loan meaning that the loan must be repaid before the other shareholders receive any proceeds.
Participating Liquidity Preference – Just like the above; however, the “participation” element of the term allows the VC to participate in additional proceeds due to shareholders. This often leads to the VC taking a larger slice of the pie than the entrepreneur. A participating liquidity preference may also feature a “multiple” component which pays the VC a multiple of their investment regardless of the company’s performance. Although this term is less common, it’s important to be able to recognise this and understand its implications if encountered on a term sheet.
Anti-Dilution – This term serves to protect investor interests in the face of a down valuation in a future financing round. Put simply, this clause gives investors more shares in the event of a down round, protecting them against dilution. An anti-dilution clause sets the terms by which preferred shares held by the investor will convert to ordinary shares so to protect the original investment value. Typically, there are two ways the conversion is calculated:
1) “Full Ratchet” which re-values preferred shares to match the new lower price of the newly issued shares. This is less common and if the new financing round is at half the value of the original, the investor voting rights effectively double.
2) Weighted average conversion re-values the preferred shares at a rate which is proportional to the investor’s preferred shares/ total shares.
While only a few terms have been mentioned, they reveal the potential complexity that entrepreneurs may encounter while at the negotiation table. Equally, these terms highlight the balancing effect that they can have on the overall deal. Take, for example, a founder that is only concerned with high valuation. The VC may concede a high valuation and lower equity stake but balance this effect with a participating liquidation preference with a multiple. Thus, term sheets ought to be reviewed holistically and represent the goals of both the entrepreneur and the VC.
*Disclaimer: This article does not constitute legal or fiscal advice and it is for information purposes only. Collective Equity Ownership is not a Venture Capital and does not hold the ownership of the shares contributed to it by its members.