Next in a series of posts abou…
Next in a series of posts about VC term sheets. This one about Liquidation preferences. http://bit.ly/7GmmL enjoy and RT
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Startup Term Sheet – Liquidation Preference
This is the second post in a series attempting to demystify startup term sheets. If you have not read the first post about Valuation, you can find it here.
Startup Term Sheet – Talking Stock
As mentioned in the previous post, a venture capital term sheet is a letter of intent that outlines a potential investment in a startup. The first and usually most debated item is the valuation as it has the largest effect on the dilution or amount of ownership you give up in order to receive funding. Once you agree on valuation (while keeping in mind the option pool twist), it’s important to understand what you have actually sold.
As in the public stock markets, you are basically selling shares of ownership. In the case of a traditional venture capital investment, each “round” or time you raise venture funding is typically referred to as a “series” and labeled alphabetically. A first round is typically referred to as a Series A, and subsequent rounds as B, C, D and so on.
Additionally, the shares sold to investors are “preferred stock” as compared to what is called “common stock”. Common stock is what founders and employees receive. Preferred stock is given to investors as a result of providing large sums of capital and they therefore receive various preferences over the common stock holders. These preferences include liquidation, dividends, unique voting rights, veto rights, and various other protections that will be discussed in future posts.
In exchange for the additional preferences, the price per share of preferred stock is typically greater than that of common stock. This lower price is why founders and employees can typically purchase shares in an early stage company for pennies per share. The price differential is changing somewhat with new accounting rules but more on that in a future post.
This post will review Liquidation Preferences, which are potentially the most dilutive preference to the common shareholders after the valuation and option pool size.
Liquidation Preferences – What’s the big idea?
Startup term sheet Liquidation Preferences sound like a preference for who has the right to drink from the water cooler first. And metaphorically, that is correct. Liquidation preferences provide that upon a sale of the company, the preferred shareholders are paid before the common shareholders are paid anything. In other words, they drink first from the proceeds from a sale of the company.
The simplest and most desirable liquidation preference for founders and startup CEOs is an amount equal to the amount invested, also know as a “1X Liquidation Preference”. This preference basically says that the investors get their money back before anyone else. That is of course assuming there are no creditors.
Let’s go back to the example from the first post on Valuation. In that example, Series A preferred shareholders paid $4 million to invest in the company. In the case of a 1X liquidation preference, the preferred shareholders would receive their $4 million before any of the common shareholders receive any payment for their ownership.
If for example, the company is sold for $5 million, the preferred shareholders would receive $4 million first and the remaining $1 million would be split across the common shareholders – even though the common shareholders may own a greater percentage of the company.
Let’s look at an example of what would happen if the same company is sold for $50 million. An additional right of preferred shareholders is that they can convert their stock to common stock at any time. In this example, it is more beneficial to convert their preferred shares to common. Instead of simply being paid back their $4 million, they would convert their shares to common stock and instead receive their 40% ownership portion of $50 million for a total of $20 million (assuming all the option pool shares have been issued).
What’s the twist?
This seems and is actually a pretty reasonable right. The investors put up the money, which was presumably used to pay out salaries to the team, and therefore the investors should at least get their money back first. And generally, a straight 1X Liquidation preference is what I advise founders or startup CEOs to accept.
However, there are two Liquidation Preference twists for which to watch. The first is a multiple greater than 1X and the second is called “participating preferred”.
First Twist
Sometimes investors will ask for a multiple greater than 1, for example a 3X Liquidation preference. In our example, this means, that investors would get $12 million of any company sale before any of the common shareholders. Therefore, this is dilutive to the common shareholders for any sale of the company for less than $30 million as that is when it is beneficial for the preferred shareholders to convert their stock to common and participate based on their ownership. The basic math being 40% of $30 million equaling $12 million, which is 3 times, the amount invested in the series A.
Often times this will be used in the case that investors want to ensure that the founders and startup CEOs are incented to focus on long term value creation versus “flipping the company” for a smaller amount earlier. It is also commonly used in later rounds of financing where the valuation has increased significantly and the investors in those rounds want to ensure some level of return.
In general, it is beneficial to have all the preferred shareholders use the same 1X liquidation preference especially since investors typically have preferred voting and veto rights for a potential company sale that will be discussed in a later post.
Second Twist
The second twist for liquidity preferences is called “participating preferred”. This right allows that investors not only get paid their liquidation preference multiple but then can also participate in the payout of what’s left as if they had converted to common stock. That’s right, they get their liquidation preference multiple such as a 1 or 2X liquidation preference and then also participate on an “as converted basis”.
This is referred to as double dipping since they participate as preferred shares and also as if they converted to common stock. This is very dilutive since it means that effectively the preferred investors get a share much greater than their actual ownership. If investors insist on this, it is common that there is a price for the sale of the company at which this right goes away, for example a sale of the company for $100 million or more. Yet I strongly encourage that participating preferred should be negotiated out and avoided whenever possible.
Keeping It Simple
One of the reasons many term sheets today are 1X liquidation preferences with no participating preferred is because investors in early rounds of funding, are often not the primary investors in future rounds. And as a result, if a Series A investor gets aggressive liquidation preferences, then future investors will ask for the same if not even more aggressive terms which may ultimately hurt the early stage investors in addition to the common shareholders.
Therefore it’s best to keep it simple and have all preferred shareholders with a 1X liquidation preference and to be treated equally regardless of when they invested. The concept that all preferred shareholders have the same right is a legal term referred to as pari passu. If you can negotiate a 1X Liquidation Preference, with NO participating preferred and treat every Series on a pari passu basis, you are getting very reasonable terms. And as mentioned in the last post, the way to ensure reasonable terms is to have multiple potential options for investment. The more bidders you have, the more clean your term sheet will be. Stay tuned for the next post on Anti Dilution Provisions and Dividends.
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UPDATE: Continue reading the next post Startup 126 – Term Sheet Anti-Dilution
Other links and references
Startup 124: The Term Sheet – Valuation and Dilution
Download sample Term Sheet from National Venture Capital Association
Drop In Dime Photo by Chaval Brasil
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First in a series of posts abo…
First in a series of posts about VC Term Sheets. This about valuation and dilution http://bit.ly/2qeyW
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Term Sheet – Valuation and Dilution
Lots of folks have asked a very common question about startups: “What is a Term Sheet and what do all the terms mean?” In general, a term sheet is a non-binding letter of intent that outlines a potential investment in a startup. Since there are lots of terms as part of a term sheet, I will break the discussion of the terms into multiple posts to get the content out more quickly and in smaller digestible chunks.
Term Sheet – What’s the Big Idea?
Before jumping into post-money valuations, liquidity preferences and other legal mumbo jumbo, you must first decide whether you want to go down the path of taking venture capital.
The main reason to raise venture capital is because you need money to get your company off the ground or your growth is significantly constrained by not having more cash to invest. Put more simply, cash is the biggest inhibitor to your company growth.
It turns out that in some cases, you are better off growing your business organically especially in the current world of web and software as a service in which the needs for cash are dramatically lower than ever.
The Flip Side
Of course, just because you need money to grow, it does not mean that venture capitalists will want to invest in your company. Not only do you need to decide if you need funding but you should also do a gut check on if your company is right for the venture business.
At the end of the day, venture capitalists want to invest in great teams going after billion dollar markets through which they can return 5-10 times their investment. If you cannot convince a venture capitalist that your idea will achieve these results, then trying to raise venture capital is an exercise in futility.
Startup Term Sheet Basics
But let’s assume you are a good venture capital opportunity. To start, a startup term sheet is just that, a sheet of usually only a few pages with various legal terms that serve as an outline for an investment in your company. Other than the confidentiality of the term sheet itself, it is not a legally binding commitment to invest. It is basically a letter of intent. This point is very important to remember. Getting a term sheet does not guarantee your funding since it is not a legally binding obligation to invest, but it is usually a big milestone towards completing a round of fundraising.
Give to Get
To get venture funding, you have to “give to get”. And your “give” is some amount of ownership and control of the company. The question of how much ownership and control is the essence of the term sheet. This first post will deal with the question of valuation and ownership. I will get into the topics of control in future posts, but it is important to remember a term sheet is primarily about legal control versus actual control. (Read Control Freaks Are Us on how success is the best way to stay in control.)
Ownership and Valuation
While VCs use terms like pre-money, post-money, option pools, etc, the general idea for valuing and subsequently selling a portion of your company is quite simple yet with one important twist. A VC offers to buy a percentage of your company at a certain price and valuation. The price they pay is determined by first figuring out what is referred to as the “pre-money valuation”. On the simplest (though not completely accurate) level, this is how much the company is worth before the investment. This is best illustrated with an example.
Let’s say you are running NewCo, Inc. and want to raise $4 million. If a VC wants to invest $4 million, they may offer to value the company at $6 million. The $6 million is what is referred to as the pre-money valuation.
Post Money Valuation
The post-money valuation is, as you probably already guessed, the pre-money valuation plus the amount that gets invested. In this example, it is a pre-money valuation of $6 million plus the $4 million investment that results in a $10M post money valuation.
Pre-money valuation + Investment = Post Money Valuation
So What Did You Have To “Give To Get”?
The first thing you have to give is some amount of ownership in exchange for the investment. This is similar to an initial public offering in which a company issues new shares that are bought at a certain price. The amount of the company you give up is referred to as dilution. To figure out the dilution those with some good math skills probably divided the amount invested by the post money valuation and it would seem you gave up 40% of the company for $4 million dollars, right?
Amount Invested/Post Money Valuation = New Investor Ownership %
$4,000,000/$10,000,000 = 40%
The Twist
Well, there is one twist that complicates this. That twist is called the option pool. The option pool is a set of shares that will be issued in the future to new employees, board members, advisors and others. And the way traditional Silicon Valley style investing works, VCs require the option pool for these future grants to be part of the pre-money valuation.
As a result, by having more shares, which no one currently owns, included in the pre-money valuation total the VCs lower what is the true valuation of the company before the financing. You are probably thinking, “Wait, say that again? The pre-money valuaton is not really how much the company is worth?” Yes, that’s correct and let me explain in more detail continuing with the previous example.
In the case of NewCo, Inc, the investors offer to invest $4 million at a $6M pre-money valuaton. In addition, the investors require the very typical early stage company option pool equaling 20% of all the shares issued to founders, employees as well as to the investors following the financing also known as the fully diluted number of shares.
That means that instead of splitting the $6 million pre money valuation evenly across all the existing company share holders (founders and employees), it is split between all the existing shareholders such as the founders and employees as well as the shares in the option pool set up for future use.
Below is a table which compares what happens to ownership stakes both without and with an option pool.
Ownership Without an Option Pool Ownership With an Option Pool Existing Shareholders 60% 40% Option Pool 0% 20% Investors 40% 40% Post Money Total 100% 100%
As you can see, the True Valuation (this is my term and not a common term used by VCs) is actually $4M before any effect of the financing which equates in this example to 60% dilution when you count all the shares being issued for the option pool. In other words the calculation should be as follows:
True Valuation + Option Pool Valuation + New Money = Post Money Valuation
$4M + $2M + $4M = $10M
The term should actually be the “pre-money, post option pool valuation” but at least now you know what it really means. When evaluating an offer for investment, be sure to calculate the option pool to determine how much ownership you truly give up, which is the company’s dilution.
Now many of you are probably thinking, “Well, why don’t we include the option pool afterwards?” This is one of those things that simply put “just is”. It’s the way terms sheets work and you should not spend time trying to change this. The place to focus your negotiation should instead be on maximizing the pre-money valuation and managing the size of the option pool to accurately reflect the future needs to distribute shares.
The Art of the Deal
Some of you are probably thinking, “Great, so not only am I totally confused by all this math, but you have not helped me to figure out how to maximize the valuation of my company!” Unfortunately (or fortunately?), there is no magic formula. It is part science but also lots of art.
The science part is that most VCs look at what has been accomplished at the current stage of the company and have valuation ranges for each stage. The further along you are and the more traction you have, then the higher your valuation.
The art part is economic supply and demand driven negotiation which occurs between the startup and VCs. The greater the perceived demand to invest in what is a fixed supply of your company will increase the valuation.
Therefore, the key to maximizing your valuation is first to demonstrate why you have the best team to solve a problem and then to get as far along in terms of customer, product and market leadership. This will help to maximize the investment demand from a set of great investors. The more investors that are interested in what is a fixed supply of your company will result in a higher valuation. You should not go talk with every VC under the sun, but start with a focused set and work to get several of them to put forth term sheets.
Interestingly, getting a term sheet from one VC can often trigger more demand from others. A few years ago, a friend of mine made this cartoon that jokingly illustrates this point. Experience has shown that once you have multiple term sheets, you are in a much better position to maximize the pre-money valuation with the knowledge of what is the true money valuation of your company.
http://thevc.com/strips/strip08.html
The next set of posts will cover startup term sheet items regarding control such as liquidation preferences (UPDATE: The next post Startup Term Sheet – Liquidation Preferences is posted!), board of directors, and others. If you like this and want an update for future posts, feel free to sign up below for email updates or follow me on twitter. And of course, if you like this, please use the links below and share it with a friend.
Lastly, feel free to leave a question or comment if this does not make sense. Thanks for reading.
UPDATE: I’ve posted a valuation and dilution calculator that should help make this A LOT easier!
Reference Materials
- Startup Term Sheet – Liquidation Preferences
- Startup Term Sheet – Anti-Dilution
- Startup Term Sheet – Voting Rights and Protective Provisions
- Startup Term Sheet – Dilution Calculator
- Download sample Startup Term Sheet from National Venture Capital Association
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