Term Sheets are a mechanism for defining terms and conditions for an agreement to purchase a percentage of a company for some amount of capital investment.
Venture investing is an exciting topic that I’m just now diving deep into now, beginning with Venture Deals (Brad Feld & Jason Mendelson). I wanted to write a post about Term Sheets since it is closely related to technology and startup culture.
Term Sheets cover quite a bit and include a vast amount of venture jargon and terminology as a I mentioned, but some of the core economic aspects of a Term Sheet are: Valuation and Price, Employee Option Pool, Warrants, Valuation Calculation, Liquidation Preference, Pay-To-Play, Vesting, and Antidilution.
Valuation is the price, determined by the founders and investors of the company, agreed upon and expressed in two forms: Pre-Money and Post-Money. Pre-Money Valuation is the agreed upon price of the company before the additional financing from the investors. Post-Money Valuation is the value of the company Pre-Money with the additional funding from investors. For example, founders and investors agree upon the Pre-Money value of company x as $10,000,000. Now, investors want to make a $5,000,000 investment into company x. The Post-Money Valuation of company x is now $15,000,000. And the pre investment breakdown of ownership is- Founders: 100%, Investors: 0%. The post-investment breakdown of ownership is now- Founders: 66.67%, Investors: 33.33%.
Employee Option Pool is used for incentivizing and motivating new employees as they are hired. Be aware as the Employee Option Pool is an aspect of the entire company Valuation when the founders are negotiating with investors on Pre-Money and Post-Money Valuation prices. Investors may stress for a 20% Employee Option Pool which would have the most potential to affect the founders at the Pre-Money Valuation price. As an example, let’s take a 20% Employee Option Pool and refer to the previous example. Remember the investors are putting up $5,000,000 at a $10,000,000 Pre-Money Valuation, but now have included the 20% Employee Option Pool. This will not affect the investors now 33.34% Post-Money allocation. But the founders share will now be 46.67% with the 20% Employee Option Pool set aside for new hires and future employees. This means the founders bear the burden of offering equity related incentives as the investors equity is not subject to be 20% EOP. There are conditions worth negotiating, like a higher Pre-Money Valuation or deferring a percentage of the EOP until the financing is done so that the deferred percentage takes affect Post-Money.
Warrants are used as an opportunity for investors to buy shares within a company at a predefined price within a given number of years. Take the same example we have been looking at. If there are 1,000,000 shares to begin with, and the investors now hold a 33.34% ownership of the company from the $5,000,000 investment, their total number of shares comes to: 714,164 at an average cost of $7.00 per share. A warrant, for example, could allow the same investor an opportunity to buy another 50,000 shares for a price of $7.5 per share, say within a 5 year time period.
Valuation Calculation is largely based on a few important factors including what stage the company is at the time, are there other VC’s interesting in funding the same company (this kind of competition can be beneficial for companies), the previous experience of the CEO and leadership team as a whole (including experience at or founding previous startups and the success of those startups), and how large the market opportunity is (for example, the hotel industry accounted for a total of $6 billion in 2018).
Liquidation Preference outlines how money is paid out as a result of a liquidity event, such as a a startup being sold. There are aspects of liquidation preference that define the way in which the payout is divvied up, like preference, which takes into account how much will be paid out to investors per share of their original investment. Another important aspect of liquidation preference which is whether or not the shares of the investor are participating shares. But overall, those two sub-features of liquidation preference contribute to the actual amount of money investors are paid in the example of a company being sold, or dissolved for that matter.
Pay-To-Play is a very important part of the term sheet that is useful for times when the company needs to raise additional funding. This condition ensures that your original investors will need to continue to add investments in the company in future rounds in order for their preferred stock to not be converted to common stock in the company. As this will strip investors of voting right, thus incentivizing investors to continue to participate in future funding rounds.
Vesting describes the period of time before employees who may be granted stock options actually receive shares. This often comes in the form of a one year cliff where 25% or so is granted, and each month following an additional percentage is received until 100% of shares are earned.
Antidilution is a condition primary for protecting investors in cases where founders need to raise additional funding in future rounds but have to raise that capital at lower valuations. There are two forms of antidilution: weighted-average antidilution and ratchet-based antidilution.
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