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| - | The Best T... | 1.0x;When a company is sold, it's normal for investors to get their invested money back before any other cash is distributed. The most standard term here is called 'non-participating preferred,' which gives the investor the option of either getting 1x of their investment back first, or converting all equity to common stock. The investor, obviously, will choose the option that nets her more.;‘Participating Preferred,’ works differently, allowing an investor to get her 1x investment back, plus her proportional share of any cash that remains after that. This term discounts the equity of common stockholders and founders.;On more rare occasions investors may ask for multiples greater than 1x in liquidation preferences, which is a nonstandard term.;"In these early rounds, it is usually not in the investors’ best interests to ask for richer preferences, because those richer terms may be then imposed on and disadvantage them in later rounds when new investors come in," says Blake Ilstrup, the lead lawyer in Orrick's Seattle Tech Companies practice.;Founders with leverage (multiple, competing term sheets) may push for a term sheet with no liquidation preferences at all, but that is anathema to the very nature of a preferred equity investment, which gives debt holders—the investors—priority in being made whole first. The standard venture agreement has founders and common shareholders in line behind investors.;Valuation;Valuation certainly receives more scrutiny from founders, and investors, than anything else within a term sheet. This is the number that the media, to the degree that there is any media interested in the investment, talks about.;Certainly, all parties involved should spend time thinking about the right valuation. But it is often terms having nothing to do with the valuation that can be most troublesome in the future for both sides. A valuation that's below market won't hobble a company or really even strain its founders, if the company is ultimately successful.;Airbnb rather famously tried to give away 10% of its equity for just $150,000, tagging the company with a $1.5 million valuation, but the founders couldn't find any takers. The company eventually took a $600,000 investment from Sequoia, but the founders didn't have a lot of options, and so the valuation terms weren't considered optimal. But that early valuation, at this point, has made little difference to the lives of Airbnb's founders or the company itself.;For founders, it's often best to close a deal quickly with a trusted investor, and a fair valuation, and simply get back to work. Over-optimizing a valuation often isn't worth the time and goodwill that it eats up. Good investors also know that the best investments aren't worth quibbling over a $12 million valuation versus a $11 million one.;Just as important as the number in a valuation is how it's calculated, points out Orrick’s Ilstrup.;"The real action with a valuation is in the calculation of the per-share price," Ilstrup says.;For example, is the unallocated option pool included in the denominator when calculating share price? If the option pool is being increased post-closing, it can push the dilution primarily onto the founders, which is something they should be aware of.;A larger option pool with a larger valuation can sometimes be a worse deal for founders than a smaller valuation and a smaller option pool.;Cooley has a an excellent example of this.;Experienced counsel will ensure that both founders and investors get widely-accepted and fair terms on valuation, but it's important to remember that what goes into the number is just as important as the number itself.;Anti-Dilution Rights;FundersClub has an excellent, detailed example and explanation of how these things can play out within its education center.;Some investors will push for terms that seek to preserve the value of their ownership stake in the case of a down round, when company's subsequent funding assigns its shares a lesser value than the previous round.;Such terms are fairly common in investments led by VC firms.;A form of this term that fully preserves the value of an investor's stake, issuing her additional shares to make up for the lost value, is referred to as a 'full ratchet.';Full-ratchet anti-dilution rates are considered by many to be too punitive to founders and other shareholders, as it can egregiously eat away at their percentage ownership in the company and erode their interests going forward. This can be detrimental to not only the founders, but also investors, who are counting on founders to remain motivated to run and grow the company.;More accepted forms of anti-dilution rights use what are known as broad-based and narrow-based calculations, which award a preferred equity investor additional shares in a down round, but not to the same degree as a full ratchet, and thus are generally accepted as fairer for all parties.;Pro rata rights;These are also known as preemptive rights in some cases, and are often lumped into a list of term sheet stipulations dubbed 'Major Investor Rights.';Pro rata rights allow past investors to maintain their percentage stake during future financings, usually up-rounds where the value of the company and its shares have increased.;When the company brings in more investment money, it dilutes older investors' percentage stakes, even when the value of the company has sharply increased. Pro rata rights allow investors to buy more shares to keep their ownership percentage stakes roughly the same.;These rights typically get conferred to the lead investor in a round, but they can sometimes be granted to all investors in a given financing.;Pro rata rights can get troublesome when they take the form of 'super pro rata,' which allows investors to increase their stake in subsequent rounds.;For instance, this would give an investor with a 25% stake a chance to push that to 30% in the later round, so it amounts to a free option to acquire more equity for an investor. Such terms can turn off future investors and potential leads in later rounds.;Founder Vesting;There are base expectations as to how founders’ equity will be structured and how it will vest. Delving from those basic constructs sends a bad signal to investors.;A fantastic outline of all of the nitty gritty on founder’s stock can be found at Cooley’s blog.;The key things to remember:;Board seats;We mentioned above that awarding more than one board seat to a single investor usually isn’t wise, especially early in a startup’s life. Founders should expect, however, to yield a board seat to the lead investor from each major round of funding, beginning with the Series A. Investors during angel and seed rounds typically aren’t given board seats, although some VCs that lead larger ‘seed’ rounds topping $2 million may end up on the board, as these financings are more akin to a traditional Series A.;Rights of First Refusal, terms that give investors control of exits, debt, financings;Many of these were covered in Terms To Avoid, above, but we note them here because they are control terms, not financial terms.;The rule of thumb here, as always, is to align the interests of all parties. If a term gives undue influence to investors or founders, it can often lead to less-than-optimal results for the company, its prospects and its eventual exit.;Controlling against tilted terms in either direction is within the better interests of all equity holders.;Protective Provisions;In rare cases some investors will push for clauses that ask for terms that, in effect, give them complete control over a company's future. Protective provisions can stipulate that there is to be no issuance of securities on parity or senior to the VC's shares. The VC can waive this right, obviously, but it's an onerous hurdle for founders when planning the next round of funding.;"Effectively, the company cannot raise any more money without the consent, approval, and endorsement of the VC, which is not an ideal situation," says Steve Brotman, managing partner at Alpha Venture Partners, based in New York.;In Summary;Term sheets can be incredibly complex things to navigate. Having a lawyer who is experienced in the latest machinations of venture financing is critical. They will protect both sides from entering an agreement that does not meet that ultimate goal: aligning the interests of both parties.;Beyond that, the most important thing to remember about term sheets is that they should be as simple as possible. When things become complicated, it usually means that one side has gained leverage, which, more often than not, leads to suboptimal outcomes for all people involved in a startup.;Just as with any business deal, the best term sheets are those that feature no sleights of hand or buried language that could alter the investment in a seminal way.">When anybody hands over severa... |
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