Startups: The Ultimate Guide to Term Sheets - Part 2

The importance of a term sheet cannot be underestimated. Any founder who is being offered funding from a professional investor or venture capital firm will find a term sheet attached.

While the thought of receiving those much-needed funds will naturally excite you, it is imperative that before final acceptance you understand exactly what the terms involved are and what you are agreeing to.

Because of this, WOWS Global is putting down a 4-part series on exactly what term sheets are and why they are so important.

In part 2 we will explain:

• The different types of shares involved.
• Term sheet key terms and clauses will be explained (these will be continued in Part 3 of our 4-part series).

Understanding the Different Types of Shares

Startup founders that are at the stage of allowing investors into their company will already have in place a company structure and will therefore have created what is known as common shares.

To facilitate investment in your venture you will issue additional shares. When doing so, you may wish to add specific clauses that could justify creating a new share class.

An example would be to create a B class share. Holders of this class of share will have fewer voting rights than A class (original shares) shareholders.

Founders then need to consider preferred shares. These are commonly used in the startup sector because they allow for different types of rules to be set.

By definition, preferred shares carry more seniority than regular equity. What that means is those holding preferred shares have more claim on your company’s assets than regular shareholders.

While this may not appear to be a significant concern to founders during the early stages of their venture it is extremely important to understand the possible implications.

A prime example of this relates to a situation where your startup is liquidated. If this does occur, preferred shareholders are first in the queue on any returns given. Those founders considering a term sheet from VCs will typically find that these investors are issued with preferred shares.

We will shortly get into the first section of a term sheet that relates to key terms and clauses relating to ‘Economics & Control’ but along with common shares and preferred shares, a brief reminder that employee stock options also need to be taken into account.

An employer-granted stock option is…

It is common for startup founders to offer early employees and key personnel stock options as part of their employment package. This is seen as being an incentive for such employees and often acts as compensation for the lower salary accepted.

An employer-granted stock option gives the employee the right to purchase a company’s stock in the future and at an agreed fixed price. This structure means that as the company’s stock price appreciates so does the option’s value.

When an employee exercises their option to purchase shares of company stock they do so directly from the company. This is known as the grant price or exercise price and is the amount an employee pays to the startup per share. This price is set by the startup on the date they are granted to the employee (grant date).

When outside investors show interest in funding your startup they will take a keen interest in how many stock options have been issued and what type of options these are.

In summary, shares in your startup can be broadly placed in two categories:

• Common stock: This is usually the type of equity given to founders and employees.
• Preferred stock: This type of stock is given to certain investors and gives them special rights.

Key Terms and Clauses of a Term Sheet

There are various key terms and clauses of a term sheet that founders need to be aware of and understand. Below we will go through the first part of these. The remainder will be explained in Part 3 of this 4-part series.

Here are some of the critical valuation terms that founders need to understand:

Pre-Money and Post-Money Valuation

The meaning of these two terms are:

• Pre-money valuation: This refers to the value of your startup BEFORE funding is received.
• Post-money valuation: This is the estimated value of your startup AFTER receiving venture capital investment.

Here is an example of how pre-money and post-money valuations are calculated and how they differ:

Pre-Money Valuation	VC Investment	Post-Money Valuation	% Owned by VC Investor
$10 Million	$5 Million	$10 m + $5 m = $15 m	$5m/$15m = 33.33%

A valuation balance needs to be found

When considering a valuation, founders need to look for one that is not too high but neither should it be too low.

Here’s why:

• If the valuation is too high it is increasing the pressure to perform (often at unrealistic levels). It can also contribute to difficulties when trying to raise money in subsequent funding rounds.
• Accepting a valuation that is too low can result in an unnecessary dilution of a founder's shares.

How is valuation determined?

This is not an easy one to answer because valuation is generally determined by many factors. Some key pointers are:

• Market Multiple - This term is often favored by venture capital investors because it gives them a reasonably accurate indication of what the market is willing to pay for your company.

In short, the 'market multiple' valuation method works by valuing your company against other recent acquisitions of similar companies in your sector.

• Traction and growth rate.
• Where your startup is located.
• The perceived strength of your startup team.

It has already been mentioned that startup founders should seek advice from experienced advisors when considering an offered term sheet. This is particularly important when looking at valuation.

It is often the case that such advisors will recommend that early-stage founders opt for a lower valuation from investors that meet your requirements more closely than a higher valuation from investors that do not.

Liquidation Preference

In a term sheet, liquidation preference is one of the most important clauses a founder needs to be aware of. This particularly relates to the issuing of preferred stock.

Upon issuing a VC investor shares of preferred stock you are granting them specific rights. This includes the liquidation preference. Although mentioned earlier in the piece it needs reiterating that preferred stock is more valuable than common stock.

This means that if your startup goes into liquidation that preferred stockholders will have priority over common stockholders when it comes to receiving the distribution of any assets.

Straight preferred (or non-participating preferred) - Favors the company

In the event your company is sold this allows preferred stockholders to choose a liquidation preference with a liquidation multiple.

What that means is preferred stockholders have an entitlement of being paid back their total investment, plus dividends, and a multiple figure of their original investment (examples here will be written as 2X multiple, 3X multiple, and so on). 

These payments will be made BEFORE the distribution of any proceeds to common stockholders

Alternatively, preferred stockholders can decide to convert their preferred stock to common stock. By doing so, they will be treated the same as those holding common stock and will be allowed to share ratably in the proceeds.

Double-Dip (Participating preferred) - Favors the investor

This term means that preferred stockholders are entitled to the return of their total investment plus dividends BEFORE those holding common stock get paid.

On top of this, the preferred stockholders are still treated like common stockholders and because of this, they share the remaining proceeds ratably.

Hence the term “Double-Dip” because in effect they are being paid twice!

As an example, An investor puts $1 million into a startup company that has a valuation of $5 million post-money. That investment gives said investor 20% company ownership.

When the company is sold, it sells for $10 million. The investor will take 20% of that $10 million = $2 million. Then they will be due 20% of the remaining $8 million ($1.6 million) making the investor total - $2 million + $1.6 million = $3.6 million.

Capped (or partially) participating preferred - Often seen as a compromise

If this is stated in the term sheet the preferred stockholders will have the same rights as those with participation preferred status as mentioned above. However, their aggregate return will be capped.

What that means is once they have received the capped amount they do not (cannot) share in the remaining proceeds due to other common stockholders. This arrangement is often seen as a compromise.

While you can never be sure of success, this term means that should your company be a huge success, the agreed liquidation preferences will matter less. That is because your company valuation will be far larger than any original amount an investor has put in.

Should your exit be more modest, the liquidation preference could very well significantly diminish the proceeds a founder and employees receive. With those thoughts in mind, this is a term that founders need to carefully negotiate.

Conversion Rights

The meaning of a conversion right is that it gives the ability to convert preferred stock shares into common stock. While there are different conversion right types the two main ones are:

• Optional conversion rights: These are typically non-negotiable. They allow an investor to convert shares of preferred stock into common stock and are generally carried out on a 1-to-1 basis

It is an investor’s interest in liquidation preference that will decide this process. The investor's choice is between taking their liquidation preference or deciding to participate in the proportional share of any proceeds.

• Mandatory conversion rights: These are negotiable. It requires the investor to automatically convert preferred shares of stock into common stock. This happens through a process known as “automatic conversion”.

Size of Option Plans

Again, the option pool was touched on above but let’s get into further detail. The option pool consists of shares of stock that have been reserved specifically for employees.

These are usually called ESOPs (Employee Stock Option Plans) and are offered to attract as well as retain top talent. The additional benefits for ESOP holders come if the company goes public because they will be rewarded with valuable stock.

When looking at a term sheet, the ESOP is stated as a percentage of the company’s post-money valuation. What that often means is it is the founders themselves who are responsible for all of the dilution. That being the case, the ESOP element of a term sheet is taken from the founder’s stock.

As an example: An investor has a quarter (25%) of your company’s shares and the ESOP element stipulates a 20% on post-money valuation = a total of 45% - So, the founder(s) are left with 55% of company shares.

If you sell your company, all unissued and unvested options will be canceled. That being the case, the investors would proportionally share the added sale proceeds with the founder(s). This is regardless of the fact that those options are/were from the founder(s).

Keep your option pool tight!

As can be seen from the above example, thought is required when creating an option pool. While percentages vary depending upon your location they typically come in between 10-25%.

Keep in that realm and do not create a huge pool. If you do, this is likely to reduce the chance of unallocated equity. Also, remember that so-called top-ups can occur later should that be required during future funding rounds.

Dividends

A dividend is classed as a payment that is made up through the distribution of profits from a company to its shareholders. Again, there are 2 types of dividends that can be shown on a term sheet:

• A cumulative dividend: This is a right that is connected to certain preferred shares. Calculated annually it will be carried forward to the following year if the company cannot pay.
• Non-cumulative dividends: This does not have unpaid dividends carried over from previous years. It is clear that this type of dividend favors founders.

It should also be noted that not all investment rounds involve dividends.

Lots to Take Onboard - Founders Should Seek Assistance

The above Part-2 of our 4-part article series on the Ultimate Guide to Term Sheets from the highly experienced team at WOWS Global contains a lot of important points. These relate to terms and clauses which may be included in your term sheet(s) and ones that founders need to be fully aware of.

Part 3 of this series will continue with further explanations of Term Sheets' key terms and clauses.

There is so much involved in understanding a term sheet and securing a deal that is right for you as a founder and for your company. This makes it vitally important for you to seek term sheet advice and assistance.

That is where the highly knowledgeable management team at WOWS Global can be of assistance. We fully understand the importance founders attach to securing funds but we also know from long experience that any term sheet offer received needs very careful consideration.

WOWS is extremely well-placed to explain things to you in a way that makes sense. Our services cover the A-Z of startup needs and that includes advice on how to value your company as well as getting the best from any term sheet put in front of you.

If you would like to find out more about the comprehensive assistance we can provide you as a founder, please do not hesitate to reach out to us for an initial no-obligation discussion at:

support@wowsglobal.com