A term sheet is often exactly that: a sheet full of terms. As an investor, these terms go beyond simply outlining the percentage of equity received. Investor rights establish the non-equity provisions that investors have to protect against downside risks, manage strategic decision-making, and mitigate future dilution. It is also imperative to understand the meaning of these terms to understand how your investment fares against other investors from preceding or succeeding rounds.
An important aspect of any term sheet is the valuation. A pre-money valuation is the value of the company before cash is invested. Post-money valuation is typically the pre-money valuation + the newly invested capital. An investor needs to know how much their capital is impacting the post-money valuation to understand how much of the company’s overall valuation is composed of their investment.
Preferred versus Common
The type of equity investors usually purchase is “preferred” stock. The difference between common stock and preferred stock is pay-out priority. Preferred stockholders receive proceeds before common stockholders, thereby ensuring that investors are compensated before common stockholders during an exit scenario. This effect is typically compounded by liquidation preferences and participation rights.
Liquidation preferences are seen as a provision for minimizing downside risk during an unfavorable exit. In the event that the company is under distressed sale/merger or bankruptcy, a liquidation preference stipulates that an investor’s original capital investment must be returned before any other equity holders participate in the exit. Some investments may include multiples on the original investment value, which mean 2x, 3x, or more of the initial investment must be paid back to the investor before other shareholders can participate. An investor who holds both preferred equity and a liquidation preference will receive the negotiated multiple value of their investment in addition to any equity ownership they hold in the company.
Voting, Co-Sale, Drag Along, and Pro-Rata Provisions
Voting rights give investors the ability to influence decision-making within a company. Typically, investors will negotiate for voting rights irrespective of what type of equity holder they are (common vs. preferred). However, beyond just having voting rights, term sheets outline provisions that dictate how and when votes will be counted. These situations can include: changes to corporate bylaws, issuing stock, transaction approvals, and changes to the board composition. On that note, early stage investors also usually require board seats; the number depends on the existing board size and the investment amount.
Co-sale provisions (also known as “tag-along rights”) allow investors to sell their shares on a pro-rata basis alongside founders in the event that the founders seek to sell their shares to external investors. This provision gives investors a partial exit opportunity alongside the founders if there is a compelling opportunity present. If the sale is greater than 50%, it may trigger a liquidation event clause in the term sheet, forcing the proceeds of the sale to be distributed to the shareholders. These provisions help ensure that investors are protected from the unfavorable outcome where the founders decide to walk away from the company. Drag-along provisions operate in the other way, wherein a majority shareholder can force the minority shareholder into a sale.
Finally, as an investor it is important to consider how an investment will fare after future financing rounds. Pro-rata rights give investors the opportunity to invest in future rounds of financing in order to ensure that equity held today will not be diluted severely by subsequent rounds.
If you are interested in learning more about the intricacies of a term sheet, feel free to contact us at firstname.lastname@example.org.
Originally published in the November 2018 LVAM Newsletter.