Inspirational visionary, financial wizard, team captain, superstar salesperson – just some of the multiple roles startup founders find themselves taking on. While many of these responsibilities can be expected, there is one role that many founders seem to overlook – the legal advisor. Founders will find themselves overwhelmed with a barrage of technical legal jargon when negotiating terms with potential investors.
No offence to practicing professionals who have been called to the bar, but a founder can’t solely rely on the thoroughness and good faith of their legal representatives. In the event that investor relations sour, a founder needs to fully understand the terms and conditions laid out in venture capital term sheets, ensuring that they are fair and that their company is well protected by the law. Instead of bombarding you with volumes of law school syllabi, we’ve distilled the key concepts and terms every founder should know when entering term sheet negotiations with investors.
Pre-money and Post-money
One of the first things that VCs will do once you’ve entered negotiations with them is to dig up all the financial and operational records of your company. These include records of expenses, profits, revenues, salaries, customers and much more. Combined with their own projections and crystal ball predictions, they then put the figures through various mathematical formulae to give them a suitable valuation of your business. The final product of this tedious process of due diligence is your company’s pre-money valuation. The term is pretty self-explanatory – the value of your company before an injection of money (i.e. investment).
The investor then decides on the amount of money they’re willing to invest and the corresponding percentage of shares of your company that amount will buy. Add your pre-money valuation to the agreed investment, and you will get your post-money valuation. Be clear about whether your agreement with your investors are based on pre-money or post-money. The slight difference between “post VS pre” can drastically affect the number of shares you end up with. Here’s a quick example of how share percentages can be affected when using a $4,000,000 pre-money valuation and a $4,000,000 post-money valuation:
Types of stocks
If you’re speaking to investors at the very start of your business journey, these investors would generally request for preferred convertible stock. This type of stock gives the investor the best of both worlds – preferred stock and convertible stock. If you’re worried about your investors cashing out early, you need to understand the difference between the 2.
Preferred stock – gives the investor priority over others when it comes to dividend payouts, profits from an acquisition or IPO or money from a liquidation event. Preferred stockholders receive bigger payouts at an earlier time compared to regular investors or common stockholders.
Convertible stock – gives the investor the option to convert their preferred stock to common stock. Why would an investor wish to opt for smaller payouts at a later time? Common stock is much more liquid and easier to trade in the stock market. So, in the event that a company does so well and the share prices sky rocket, investors can sell quickly to earn a big profit.
It is common practice for startup founders to offer company shares to new hires. With a tight budget and a dire need for a dedicated team, offering company shares to new employees is an effective way to attract promising new talent who are skilled, and are also invested in the success of your company. These shares will be coming out of a fixed percentage of your company’s shares set aside for this purpose, also known as option pools. Keep a lookout for mentions of option pools in your term sheet as this will affect the overall value of your shares.
Have a hiring plan that will see you through the next few years or until your company becomes profitable. Make sure that the percentage of shares that will be set aside in your option pool is in line with your hiring plan. Below is an example of how an option pool of 20% shares affects the value of your own shares:
As a safeguard against the issuance of new shares, a fall in share prices or the company’s valuation, anti-dilution policies ensure that the shares owned by the investor will not be ‘diluted’ (drop in value). Here’s an example of how shares can be diluted: your company goes public and lists on the stock exchange at $10 per share. In the meantime, your investors paid $12 for each when they first invested in your company 5 years ago.
No sane person gives money away for free, and because of that, anti-dilution clause that will definitely feature on your term sheet. The policies will ensure that investors will be able to retain the original $12 value of their shares. As a founder going face-to-face with term sheets, keep an eye out for the proposed anti-dilution mechanisms. Here are the 2 options:
- Full Ratchet
This mechanism allows your investor to retain the original dollar value of their investment. For example: your company originally sold 20% worth of shares to investor A at $1,000,000 with a post-money valuation of $5,000,000. Your profits have tanked, and you’ve attracted a new investor B who now values your company at $2,500,000. Under the full ratchet mechanism, investor A still holds $1,000,000 worth of shares based on the new valuation of $2,500,000, which now equates to 40%.
- Weighted Average
There are many different formulas that can be used for weighted average anti-dilution mechanisms. There’s the broad-based calculation, the narrow-based calculation, and many other variants in between. The main takeaway is that unlike the full ratchet, the original dollar value of investments will not be completely unchanged. The value of initial investment that will be retained depends on the type of calculation used.
There is a litany of technical terms that are littered across investor term sheets. Knowing the key terms will help to even out the playing field when negotiating with investors on your term sheets.