Hi there! In the 2nd part of my crash course series pertaining to how the VC industry is being operated, I’ll be covering another segment as per the book’s content, Venture deals by Bred Feld and Jason Mendelson. The main coverage in this post will consist of:

  1. Economics terms of the Term Sheet
  2. Control terms of the Term Sheet
  • WARNING: This post will be rather dry, so be prepared to put on your thinking cap and stay vested till the conclusion. Nevertheless, these nuances are important especially when you sit in/engage in a VC discussion regarding valuation and negotiation.

Economics of a Term Sheet

In a VC context, economics refer to the returns investors will ultimately receive in a liquidity event, usually stemming from either a sale of the company or an IPO. This will include specific terms that have a direct impact on their returns. These are important key concepts to register apart from the valuation, as the sum of money you will receive in the end may not to amount to the fair value that you have dictated the company to be.

Price

Price is the first term that every investor will be laying their eyes on. On the term sheet, you’ll purchasing shares of the company at $XX/share. This will be settled at a pre-money valuation of $XX million and a post-money valuation of $XX million. Usually, the price will be tabulated upon identification of the pre-money valuation.

Price/share = Pre-money valuation / Total number of shares outstanding

Breaking it further,

  1. Pre-money valuation: Valuation of the company as of today
  2. Post-money valuation: Pre-money valuation + aggregated amount of investment pumped upon closing the Series funding phase.

Usually, the price per share will mention that it is fully diluted. This indicates the inclusion of all other hidden terms such as the convertible debts, stock options and many other terms that we agreed in the previous round. Further insights on it can be found at Venture Deals I, where I initiated some coverage on the capitalisation table. There are many rationales for such a term to be in place. For example, investors of the current Series funding will not want to be diluted further if the company were to include a CFO, COO, CTO post funding, which results in having to issue employee options that were not included in the previous round [1]. Moving forward, this will cause further dilution with the remaining shareholders.

Other common terms that you will identify with that resonates with the price per share are warrants and bridge loans. Warrants is similar to a stock option which allows shareholders to exercise a right to purchase a specified amount of shares within a certain amount of years. The warrant eventually disregards any future valuation that is set upon the company. For example, a seed round issue of warrants that allows the VC to purchase 1,000,000 shares at $10/share (as valued during the seed round) will still enable the VC to enact that purchase, irregardless if the Series A valuation is settled at $100/share. Bridge loans on the other hand act a little similarly as a convertible debt, by which the bridge loan is converted into equity at the price of the upcoming financing.

Liquidation Preference

Liquidation is usually defined as the sale of the company’s assets, which is particularly important when a company is sold for less than the amount of capital invested. Within a liquidation term comes another subset ; participation. This happens where upon liquidation, the supposed investor will receive $XX FIRST, with the remaining proceeds being distributed to the remaining investors. Further, if there is a multiple involved with the participation, it means that if the valuation doesn’t exceed the multiple * initial investment involved, the VC that has the liquidation right will have their portion of returns first.

This may sound really confusing, so let us support this with an example and lay our certain parameters.

  1. Suppose we have Bottles&Co finished a Series A funding of $5 million with a $15 million pre-money valuation.
  2. Investors own 25% of the company with the founder, Jeremy, owning the remaining 75%.
  3. Liquidity preference is stated at 1x.
  4. Participation preference is stated at 3x.

Situation 1: Bottles&Co will be acquired at a valuation of $100 million

Since the participation preference of 3x(amounting to a total value of $15 million) is lesser than what investors will receive if they were to split 25–75, the participation preference will not take effect. As a result, the investors cash out with a value of $25 million with Jeremy cashing out $75 million.

Situation 2: Bottles&Co will be acquired at a valuation of $15 million

This is where things get interesting. As the participation preference multiple is now higher than the split ratio value, investors will now acquire all of the money($15 million) due to its participation preference, leaving Jeremy for nothing.

Situation 3: Similar acquired valuation of $15 million but without the participation preference.

The investors here will acquire its original investment of $5million, followed by a split of 25–75. Hence, investors and Jeremy will receive $7.5 million each.

  • There are definitely more complicated scenarios that will arise, but this will provide a brief overview of what liquidation preference results into.
  • Things get more messy especially when there is constant liquidation preference along with the company moving down the Series funding of A,B,C ….. This is where the investors will settle for two options. Stacked preferences will allow investors that funded the later rounds to have their liquidation preferences settled first. On the flipside, blended preferences will be that investors across various funding rounds share pro ratably until the preferences are returned (based on the proportion of investment they have made with the company).

Pay-to-Play

This is a play that protects entrepreneurs in case they face financing issues during their subsequent funding along with tight cash flow issues. Investors in this case, have to keep participating in future financing(pay), or risk having their preferred stock convert down to common stock(play). As such, they will lose or their preferential rights such as liquidation preference, dilution protection, voting rights, etc… Hence, this pay to play is derived, similarly to how we often pay in certain games to have an unfair advantage :)

*There are other key terms such as vesting, employee options and anti-dilution in the economics of the term sheet, but i have found the above to be of higher importance. Further, I’m not very well versed in anti-dilution but when I do grasp the concept better, I’ll come back to this post and give it another look.

Controls of a Term Sheet

VC are also concerned with certain controls in the term sheet as it allows them to keep and eye on their investment, have a general direction and have some voice in terms of setting the company’s mandate.

Board of Directors

This is setting up the clause of the size of board here, including which personnel and what they are entitled to in terms of voting, etc.

Protective Provisions

Protective provisions are veto rights that investors have on certain actions by the company. This allows them to protect themselves against certain abrupt decisions like selling of the company, changing the terms of stock owned by the VC, changing the size of the board, etc.

Drag-Along Agreement

This agreement will give the subset of some investors the ability to enforce, or drag along all other investors and founders to a sale/liquidation of the company, regardless of their consent or not. This is due to the fact that, they have already consented to this drag-along agreement!!

With that being said, I have come to an end of what I deem to be important for someone that is trying to get to understand the VC world a little better. There are definitely more clauses in the term sheet and when I achieve that high level of proficiency, I will be adding my viewpoint and summary into this. Nevertheless, thank you for tuning in and I hope you have gotten something out of it!

[1] Shareworks. (2020). Retrieved 21 May 2020, from https://discover.shareworks.com/a-private-company/understanding-convertible-debt-and-how-it-affects-your-cap-table

Always interested over topics on venture capital, start-ups, macroeconomic outlook & equity research on different sectors.

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