Startup 129: Term Sheet – Board of Directors
This post is a continuation of the series about venture capital term sheets. If you have not yet read the previous posts on Valuation and Dilution, Liquidation Preferences, Anti-Dilution, and Voting Rights and Protective Provisions, you might want to start with them. In particular, when thinking about the Board it’s important to understand investors Voting Rights and Protective Provisions, and the requirement of investors’ consent on certain decision. (The links are at the bottom of the post as well…)
There are lots of things to consider for a startup’s Board of Directors including its role, who should be on it, and how to best work with the board.
You’re Fired! (or Hired)
To start, a Board of Directors has one primary job, which is to hire and fire the CEO. Sounds a little like your worst Donald Trump nightmare, eh? What this truly means is that the Board is an oversight organization for all the company’s shareholders and an advisory group for the company’s management.
The Board ultimately holds the CEO and the executive team accountable for meeting agreed upon objectives, manages compensation for the top executives, and works with auditors to ensure appropriate accounting and business practices. This is their “ongoing” job. Additionally, over the life of the company, the Board will vote on key decisions such as raising more money or selling the company.
Term Sheet
Typically the language in a term sheet is very straightforward and will simply outline the number and names of people on the board. The Series A will set the basic blueprint including the representation of the common shareholders and founders. The following example language is from the NVCA’s sample term sheet:
“At the initial Closing, the Board shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors].”
Not only is this common language, but this also happens to be a very ideal structure with two investors, two common shareholders including the CEO and then an outside, non-employee and non-investor board member. It’s ideal because all shareholders are represented and if needed, the outside board member can serve a tie breaking function.
As you raise additional rounds of funding, almost every investor will want a seat on the board which can get quite unwieldy. I strongly encourage companies to have a small set of board members (ideally 5 but no more than 7) who appropriately represent the shareholders. Only if needed, offer to future investors “Board observation rights”. Observer rights allow an investor to sit in on a board meeting but they are not voting members of the Board.
The Board is Your Team
Choosing your board members is as important, if not even more important than the structure. Think about each board member as if you were hiring them to work for the company. Do they have certain technical competencies that make the company better? Ideally each board member brings experience with startup execution or understands the business and market or both.
It is also important that they have the right relational competencies to work well with you, the rest of the board and the entire company. A board of successful people does not necessarily mean a successful board. They have to work well together. (Read It’s the people, stupid part II for more on relational competenticies.)
Making the best of it
Now that you have the board set up, the question is how to best work with your board. Despite what many fear, the Board is not responsible nor does a good board want to run the day-to-day operations of a company. Does that mean that the Board will simply let you do what you want? Probably not but if your board wants to run the company then you have not put together the best Board or, and I hate to be blunt, it could be that you are not doing a good job.
The key to a successful board relationship is leadership. Being a good leader means you have followers. And the best way to have the board “follow” you is to set a plan, deliver on the results and keep in regular communications especially sharing bad news early. I have never heard of a successful company having a difficult board dynamic.
For more on this idea, I suggest you check out the posts If you don’t know where you’re going, well, you’re lost, and A few golden rules for a great Board relationship, and Control Freaks Are Us to learn more about how to ensure a successful board relationship.
Anyway, I hope this helps. Enjoy the other posts and please feel free to share your thoughts or questions. And to get notified about future posts, please to sign up for email updates or follow me on Twitter. Thanks, feel free to share the post with your friends, and go get started…
Related Posts and References
- Startup 124: Term Sheet – Valuation and Dilution
- Startup 125: Term Sheet – Liquidation Preferences
- Startup 126: Term Sheet – Anti-Dilution
- Startup 127: Term Sheet – Voting Rights and Protective Provisions
- Startup 131: Term Sheet – Dilution Calculator
- It’s the people, stupid part II
- If you don’t know where you’re going, well, you’re lost
- A few golden rules for a great Board relationship
- Control Freaks Are Us
- Download sample Term Sheet from National Venture Capital Association
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Startup 128: An Interview with Bill Gurley of Benchmark
This post is an email interview with Bill Gurley of Benchmark Capital. I sent Bill 10 questions on what he looks for in his investments, the people he backs, the state of the venture capital business and why Benchmark invested in Twitter. Enjoy.
On Venture Capital investing today
1. What are your top investment areas going forward?
We don’t really work that way. All I could tell you is what are the three most common investment themes looking back. We simply don’t sit around planning the future. We try to meet with as many great entrepreneurs as we can and then make a judgment on the quality of their vision versus the state of the market. Recent themes have been cloud computing, open source, user generated content (UGC) Internet plays.
2. What are the most important things you want to learn about a company in a first meeting?
• Quality of the idea – this is from both an economic standpoint and a defensibility standpoint.
• Quality of the founder – smart, motivated, goal oriented.
• Mode of operation – frugal vs. excessive.
3. It seems most VCs keep a list of deals they “missed”. What’s your list?
It’s long and painful.
I met with all of these companies at an early stage before they raised venture capital.
• Overture – Bill Gross was kind enough to show this to me
• Akamai – this was Mark Gorenberg’s deal at HummerWinblad, but I should have been supportive, and I missed it
• Skype
• Baidu
• And of course the big one: Google. I have profound admiration for John Doerr and Mike Moritz for knowing to step up here, especially at a high price. It was far from obvious.
I probably forgot 1 or 2, and I am confident there will be more.
On Entrepreneurs and Startup CEOs
4. On the “qualitative” side of things, what do you look for in a entrepreneur or startup CEO? and what turns you off as well?
On:
• Intellect
• Salesmanship without being overly promotional
• Pragmatism
• Resourcefulness
• Confidence
Off:
• Overly promotional
• Doesn’t listen
• Unwilling to focus
• Lack of appreciation for finance/economics.
5. What are the top 3 do’s and don’ts for an entrepreneur presenting at a Benchmark partners meeting.
I would suspect they are mostly the same (as question 4).
Here are a few tactical things for the partner meeting presentation
• Don’t bring people that don’t have a role in the meeting
• Always include at least one “financials” slide even if its more about costs than revenues — weird to have to ask, and even weirder to reply “we don’t have one with us”.
• Don’t use over 20 slides.
• Control the flow of the meeting.
On the Business of Venture Capital
6. Opentable (Nasdaq: OPEN) is one of the first “silicon valey” initial public offerings (IPO) since the economic downturn. Why do you think the company was able to get public and was received so well?
I actually believe that the buy-side has ample demand for IPOs. The key problem is a supply problem – most companies either don’t want to be public or aren’t willing to make the tough choices it takes to get public (healthy margins, sarbox implementation, etc).
Being public isn’t easy, and for the CEO and the CFO it’s downright brutal. I think that’s why the valley is obsessed with “alternative markets” these days. They want the benefit of liquidity without the headache of being public. I think they will be disappointed.
7. What do you think about the suggestion that today’s venture model of large funds and big investments does not work in a world where companies can get real traction both as a consumer company or a enterprise company by leveraging services such as amazon’s ec2 and all the available open source solutions?
I don’t think the data proves this theory out. With the exception of Salesforce.com and Siebel, I don’t know of any multi-billion dollar public companies that didn’t have venture capital. You might be able to build a feature for $1mm, but its much harder to build a company. All of the $B Internet companies have/had venture backing.
This doesn’t disqualify the accusation that some funds are too large. They are different issues.
8. Clearly, the startup world is much more “flat” with companies existing across borders and getting started around the world. What is your long-term view on Silicon Valley as the “epicenter” for venture capital in the next 10-20 years?
We are tremendously excited about the future of Silicon Valley — it is our unquestionable focus as a venture firm. We want to be the best firm in Silicon Valley.
That’s not a reflection on the opportunities elsewhere. I happen to be very bullish on China, Russia, and Brazil when it comes to venture opportunities. I just think those will be best served by local firms on the ground in those regions.
9. Benchmark has a unique structure in that all partners are equal – equal pay, equal carry, equal votes, etc. Why has that worked and why haven’t more firms adopted that model?
It works for 3 key reasons.
First, our partner’s don’t need to negotiate compensation every time they raise a new fund, so we are incented to all work together versus proving our worth to one another. My partners deliver value-add to the companies I work with all the time.
Second, it keeps a high bar on who comes in. There is no junior team at Benchmark.
Lastly, as an entrepreneur, you are always dealing with a General Partner that has a say in the firm — your deal won’t get trumped by the “Senior partner” back at the shop.
Others don’t adopt it for the same reason other partnerships in legal, investment banking, and real estate haven’t — it’s good to be king (from a financial standpoint).
On Twitter
10. Benchmark recently invested in Twitter at a pretty lofty valuation. What drove the investment and how are they going to make money other than the often-rumored acquisition?
See my answer to question #3 above.
———-
I hope you liked the post and feel free to leave a comment or question and I will relay to Bill.
Lastly, if you like this, please share it with friends using the buttons below. And, if you want an update for the next post, sign up below or follow me on twitter. Thanks.
More info
- Startup 124: Term Sheet – Valuation and Dilution
- Startup 125: Term Sheet – Liquidation Preferences
- Startup 126: Term Sheet – Anti-Dilution
- Startup 127: Term Sheet – Voting Rights
- Follow Bill on Twitter
- Bill Gurley’s Blog
- Benchmark Capital
- Full Disclosure – Benchmark invested in my last company, Vontu. I am also very proud that Bill recently rode up the mountain from which it’s named. Mont Ventoux. Here’s a shot of him on the summit.
- Home page photo of Bill from http://www.flickr.com/photos/briansolis/
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Startup 127: Term Sheet – Voting Rights and Protective Provisions
This is the latest in a continuing series of posts about venture capital term sheets. The first three dealt with term sheet issues around ownership, dilution and the impact of Valuation, Liquidation Preferences, and Anti-dilution. You might want to start with those three posts before diving into this latest which covers Voting Rights and Protective Provisions that venture capitalists require in their term sheets.
Voting Rights – What’s the Big Idea?
Voting Rights are pretty straightforward. The language you will find in a term sheet usually looks something like this:
The Series A Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series A Preferred as a class shall be entitled to elect [_______] members of the Board (the “Series A Directors”), and (ii) as required by law.
Voting on “an as-converted basis” means that in the case of any shareholder votes except for the Board Seats and assuming there have been no triggers for anti-dilution, the preferred shares convert on a 1:1 ratio and everyone votes based on their company ownership and the majority rules. But of course, it’s not as simple as that. And while Board seats are very important, before you think about how to structure a startup board, there is something even more important to understand which are called Protective Provisions.
Protective Provisions – What’s the big idea?
In general, the Board of Directors approves most strategic management decisions. And for most decisions requiring a shareholder vote, everyone votes based on the number of shares they own. However, there are certain things that investors get to decide (or at least must consent to) regardless of their ownership stake or make up of the Board of Directors. These include:
- Any sale or dissolution of the company
- Issuing new shares of stock
- Changes to the size of the Board of Directors
- Creating, owning or selling any subsidiary
- Any change to the certificate of incorporation or Bylaws.
- Changes to any rights of other shares which give the same or better rights as their preferred shares
- Purchases or any dividends on stock before the preferred shares
- Issuing any debt
In many ways, Protective Provisions are as important, if not more important, to understand as how to organize your Board of Directors (which will be the next post). Investors include them so that when the preferred share holders are a minority, they are protected against certain actions of the majority such as a the possibility that a majority of the shareholders being able to sell the company to a family member for $10 and as result, wiping out the investors. In general, they are reasonable protections when they serve as protections as opposed to control.
Protective Provisions – How do they work?
Protective Provisions are actually pretty straight-forward. There is the list of decisions to which the preferred shareholders have to agree or consent before the company can act. There is some negotiation for items such as taking on debt, as usually there is some threshold below which the company can take on debt without consent. Though most of the items are not very negotiable.
However, what is negotiable is how the Protective Provisions work when you raise multiple rounds of funding. They can either work in such a manner such that all the preferred shareholders vote together as a class regardless of when they invested or alternatively each series of preferred shares have the right to vote separately for each series on the protective provisions. As I will explain, having all the preferred shareholders vote as a class is in the company’s best interest.
Let’s take the example of a company that has raised one round of funding, called a Series A, in which the preferred shareholders own 30% of the company. In this case, the preferred shareholders have to vote on any of the itemized protective provisions and it’s simple.
Now what happens in the case that you raise two additional rounds of funding, a Series B and a Series C? Each time you raise a new round, it’s in the best interest of the company that the preferred shareholders vote all together and share the protective provisions otherwise you could have a small minority shareholder that has veto rights over what are big decisions. For example, let’s assume the Series B owns 15% and the Series C owns 5% of the company. If the Series C had their own protective provisions, then a 5% shareholder could veto a decision to sell the company even if 95% of the rest of the shareholders voted to sell the company. This is an example of how a protective provision can become a controlling provision.
Additionally, there is one other twist, which is the threshold for the voting in the protective provisions. In general, it is in the best interest to have a majority or close to a majority, such as 60% because again, this is supposed to be a protective provision and not a controlling provision.
In summary, while a company may think that the make up of the Board of Directors is the most important item, it turns out that the protective provisions give the preferred investors quite a bit of power over key decisions. Does this mean that the Board does not matter? Absolutely not, and that will be the topic of the next post.
I am also going to interview Bill Gurley of Benchmark Capital this week. Send me your questions for him via the Contact form.
Lastly, if you like this, please share it with friends using the buttons below. And, if you want an update for the next post, sign up below or follow me on twitter. Thanks.
More info and References
- Startup 124: Term Sheet – Valuation and Dilution
- Startup 125: Term Sheet – Liquidation Preferences
- Startup 126: Term Sheet – Anti-Dilution
- Download sample Term Sheet from National Venture Capital Association
- Ballot Box photo from http://www.flickr.com/photos/thomasroche/
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Term Sheet – Anti-Dilution
This is the third post in a series attempting to demystify term sheets. The first two posts are on Valuation and Liquidation Preferences and are a good place to start.
Delusional on Dilution
As mentioned in the previous posts, a term sheet is a non-binding letter of intent that outlines a potential investment in a startup. Much of what a term sheet covers is the value of the company and how much ownership the founders and other shareholders give up in order to get the investment. The amount of ownership a company gives up is called dilution. And between valuation discussions, liquidation preferences and especially with the math for anti-dilution, this whole process might start to make you a little delusional. But hang in there, as this is the last big term dealing with dilution.
Term Sheet Anti Dilution – What’s the Big Idea?
In addition to giving up a stake in the company, when you raise venture capital, in a term sheet investors typically get additional protection rights that, in certain cases, their ownership stake will not be diluted. This primarily deals with the case when a future investor gets a better price to invest in the company. The term is referred to, as you already guessed, Anti-dilution.
Anti-dilution is a price protection guarantee not unlike, for example, when a store like Best Buy guarantees it will make up the difference on the price you pay for a camera if you find it for a lower price later. In reality, you only have to worry about this term if you have a down round. A down round is when a follow on investment is made at a pre-money valuation that is lower than a previous round’s pre-money valuation. (Don’t know what pre-money means, then check out the post on Valuation.)
As a result, based on how well you execute you have lots of control to avoid having investors ever use this protection. (See previous post Control Freaks are Us). Plan, execute and deliver results and odds are that even in tough times your valuation will increase from each round. But let’s look at how this works in the case you do have a down round.
How it works
As mentioned earlier, Anti Dilution is basically price protection for the investors. Let’s go back to the example used in the previous two posts in which NewCo, Inc. sells shares in a Series A investment at a pre-money valuation of $6 million and raises $4 million of new money. If there were 6 million shares (4 million for the founders and employees plus 2 million for a 20% option pool), that would price the shares at $1 per share ($6 million/6 million shares). By raising $4 million, NewCo, Inc. issues 4 million new shares at $1 per share to the investors for a total of 10 million shares.
Following so far? I hope so because that’s the easy math!
Let’s say for some reason that disaster strikes and NewCo misses most of its goals, the economy goes into recession, and yet the company needs to raise more money. NewCo, Inc. gets an offer from a new investor to provide $1 million for a Series B at a $5 million pre money valuation. Since the post money of the Series A was $10 million and the pre-money of the Series B is $5 million, this is referred to as a down round. In this case, the Series A Anti-dilution protection would kick in.
There are two types of Anti-Dilution preferences – Weighted Average and Full Ratchet. Let’s start with the most common, which is a weighted average formula called “Broad based weighted average”. According to Wilson Sonsini, a leading Silicon Valley law firm, 92% of their term sheets in 2008 used Broad-based weighted average. And that’s good news, because it is the most favorable for the company other than not having any Anti Dilution which is probably not going to happen for most companies.
So what happens?
Basically, Anti-dilution lowers the price at which preferred shares convert to common stock. As mentioned in the previous post on Liquidation Preferences, in the case of a sale or an IPO that exceeds the minimum liquidation preferences, preferred shares convert into common stock. In the case of Anti-dilution, when the conversion happens, the preferred shares convert at lower price so that preferred shares receive extra shares of common stock as their price protection.
In the case of broad-based weighted average, the idea is to lower the original conversion price to a number somewhere between itself and the new price per share based on a weighted average of the shares issued in the down round and the number of shares that would have been offered if the round had been at the price of that investors round.
And now for the fun part – Algebra.
The formula to calculate the conversion rate is:
((Fully Diluted Shares pre-down round + Shares issuable if investment had been at higher round price) / (Fully Diluted Shares pre-down round + Actual shares issued in down round)) * Original Conversion Price
In our example of NewCo, Inc, the new conversion factor is calculated as follows:
(10,000,000 shares + 1,000,000 shares)/(10,000,000 shares + 2,000,000 shares) * $1 = $.92
- The 10,000,000 shares is Fully Diluted Shares following the Series A, all common shares help by founders and employees, all allocated in the option pool and all preferred shares help by investors.
- The 1,000,000 shares issuable is calculated based on if the investment had occurred at the Series A price by dividing the $1 million new investment by the Series A price per share which was $1.
- The Actual shares issued in the down round are calculated by determining the price per share ($5,000,000 pre-money valuation divided by 10,000,000 shares outstanding) of $.50 and then dividing the investment amount by the price per share ($1,000,000/$.50) which equals 2,000,000 shares issued in the down round.
- The $1 is the Series A price per share and conversion price.
As a result, the 4 million Series A preferred shares would eventually convert by dividing the total numbers of shares by the new conversion price.
4 million shares / .92 = 4,363,636 shares.
The 363,636 additional shares is the result of the Anti Dilution protection for the series A. In summary, the idea for a broad based weighted average anti-dilution is that investors get some protection based on the weighted average of all the shares in the company on a fully diluted basis. Of all the alternatives, this is the most reasonable and desirable for the company.
What are the Twists?
First, if there is more than one round of funding prior to a down round, then each round would go through a similar calculation. The difference being the “Shares issuable if investment had been at higher round price” uses the price for each round. This is not really a twist but causes further dilution as each round gets a new and lower conversion price.
Secondly, you will sometimes see something called “Narrow-based” weighted-average. These are far less typical and the difference is basically that it excludes unexercised options, warrants and the like. As a result, the new conversion rate is lower and more favorable to investors than broad-based weighted-average formulas.
Rachet and Clank
Lastly, there is the dreaded Full Ratchet. This is much simpler to explain yet thankfully in only about 5% of all term sheets though it was in 10% of 2008 down round term sheets (Again all data from Wilson Sonsini). How this works is that the lower price of the down round simply becomes the new conversion price. In our example, the Series A investors would convert at $.50 per share instead of $1. This means they would end up with 8 million versus the 4.3 million shares under the broad based weighted average. (4 million shares divided by .5) Clearly this is painful and it’s not that common because it dilutes the founders and employees to a point, that it’s not in their interest to stay for the long term as their stake is no longer meaningful.
Additionally, the earliest investors avoid using this because it may never benefit them and if the down round is higher than the Series A price, it may only cause dilution for themselves.
Summary
This has been a long post with lots of math so thanks for hanging in there. In summary, most every term sheet has Anti-dilution. If you can, focus on getting a broad based weighted average formula and then make sure you execute well so that this never comes into play.
UPDATE: Posted the next in the series Startup Term Sheet – Voting Rights and Protective Provisions
Please feel free to leave a comment or ask a question if something does not make sense.
And of course, if you like this, please share it with friends using the buttons below. Lastly, if you want an update for the next post, sign up below or follow me on twitter. Thanks.
More info and References
- Startup Term Sheet – Valuation and Dilution
- Startup Term Sheet – Liquidation Preferences
- Download sample Startup Term Sheet from National Venture Capital Association
- Wilson Sonsini Term Sheet Metrics
- Rachet and Clank picture copyright Sony Computer Entertainment
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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.
And please leave a comment or ask a question. And of course, if you like this, please share it with friends using the buttons below.
Lastly, if you want an update for the next post, sign up below or follow me on twitter. Thanks.
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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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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