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

Price

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

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

*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

Board of Directors

Protective Provisions

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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