Feature Story

 

Making Sense of Venture  Term Sheets

 

By Chris Anderson

 

If you are soliciting or hoping to receive a term sheet from a venture capitalist or angel investor, or expect to discuss with potential investors the terms on which they might make an equity investment in your development stage company, prepare yourself. Investors use a lot of terms that may be unfamiliar to you. A little homework will help you speak and understand the lingo, and to know which terms are likely to have the most significant impact on the founding stockholders and their investments. The following is a simplified key to understanding a few of the new terms that might start swirling around you as you look to raise needed equity capital.

 

Common Stock vs. Preferred Stock

Common Stock is the basic ownership unit in a corporation. The holders typically have voting rights, and the right to receive the net assets of the corporation upon dissolution, subject to any preferential rights granted to holders of Preferred Stock. Preferred Stock consists of a group of shares that are given certain rights and preferences regarding matters such as voting, dividends, liquidation preferences, conversion rights and anti-dilution protections. Investors typically like Preferred Stock, because of the rights and preferences that can be built into the shares. And having investors purchase Preferred Stock can also have a benefit to the company, as it can maintain a differential between what the investors pay for their shares, and the price at which Common Stock may be sold to employees.

 

Pre and Post-money Valuation

A pre-money valuation is simply the value established for the company immediately prior to giving effect to the financing. A post-money valuation refers to the state of affairs immediately after completing the financing, and is simply the pre-money valuation plus the amount of the investment. So when a valuation figure comes up, any given number is more attractive as a pre-money valuation, because the post-money valuation will by definition be higher, and the purchase price per share will be based on the pre-money valuation (and is simply the valuation divided by the number of shares outstanding — or deemed to be outstanding). Note that investors will want your option pool created and in place pre-money, so that the reserved shares are counted as the stock price is computed, with the effect that the founders and not the new investors are diluted by the option shares.

 

Liquidation Preference and Participation Rights

Pay attention, as this provision will have the most direct impact on the return ultimately realized by the founders, when the proceeds of a liquidation transaction are divided up. A liquidation preference is the amount the purchasers of Preferred Stock are entitled to receive before the holders of Common Stock get anything. It is typically calculated in reference to the purchase price paid for the Preferred Stock. The basic right would be a return of that investment (plus any dividend that is owed). However, in an investor favorable market, a 2x or 3x return on investment may be requested, before the holders of Common Stock get anything. A participation right means that after the preferred investors get their preferential payment, they also share in distributions made to the holders of Common Stock, typically on a pro-rata basis. A company may negotiate for a cap on what the holders of Preferred Stock may receive in a liquidating transaction. And remember, if the return to a preferred investor would be less that what the holders of Common Stock will get, the investors may convert their shares to Common Stock (and they may be required to convert on certain events, such as a qualifying IPO). It is worth running through a few examples to see how the investors and founders would each come out under various exit scenarios.

 

Anti-Dilution Protections

A mechanism to protect the investors from having overestimated the value of the company, or in the event of a downturn in company fortunes. Implemented by changing the conversion rate of the Preferred Stock, so the investor gets more shares on conversion if the company issues shares to others at a price below what the investor paid. Can be in the form of either a "direct ratchet" or "full ratchet" adjustment — with the investor treated as if having paid the lower price, or a "weighted average formula" adjustment — with the investor benefiting from a weighted average adjustment to the conversion price, based on the number of shares issued at the lower price.

 

Pay-to-play

Extends the benefit of the full anti-dilution protection and to participate in future offerings only to investors who participate in the lower-price offering.

 

Dividend Rights

Generally, a dividend must be paid to the holders of Preferred Stock before any dividend is paid to the holders of Common Stock. The dividend may be non-cumulative and discretionary, or it may be cumulative so that it accrues until paid. The Preferred Shares may also be entitled to participate in any dividends that are then declared with respect to the Common Stock, on a pro-rata basis. The board of directors typically decides when dividends are going to be declared. Development stage companies don't typically pay dividends, but an accruing dividend may have to be paid out in an exit transaction.

 

Co-sale Rights

A right granted to investors to participate in a sale of shares by founders or other designated stockholders. So if the designated stockholder wants to sell shares, the preferred investors can participate as sellers in that transaction.

 

Drag Along Rights

A right to require founders or other designated stockholders to go along with an exit transaction approved by the preferred investors.

 

Redemption Rights

A right to require the company to repurchase the Preferred Shares at a specified price (often the issuance price plus the amount of accrued but unpaid dividends), typically triggered by a vote of the preferred investors at some time in the future. This gives the investors leverage in exit discussions, but not frequently carried out.

 

Registration Rights

Rights to require the company to register shares, to facilitate their sale to the public. This gives leverage to the investors holding such rights, but typically the underwriters engaged by a company will ultimately dictate what will happen and when.

 

Warrants

Just rights to purchase additional shares (often Common Stock) for a period of time into the future at a fixed price, giving the investors an additional "kicker" in case the company does well.

 

There are many other terms to consider, as well as variations on the terms indicated above. But hopefully, this introduction will help you feel more comfortable as you begin your discussions with investors. Also, don't forget the importance of soliciting input from professional advisors and entrepreneurs who have been through the process before, as you contemplate term sheet negotiations. They can help you identify investor demands that exceed contemporary market norms.

 

Chris Anderson is a partner at the law firm of Ballard Spahr Andrews & Ingersoll. He is in the Business and Finance Department and is also a member of the Technology and Emerging Companies Group, Mergers and Acquisitions Group, Securities Group, Private Equity Group and International Group. He practices primarily in the areas of business, securities and international law.

 

Launch - Summer 2008

 

 

For the full "digital magazine" version of Spring 2008, visit: www.nxtbook.com/nxtbooks/growutah/launch_2008summer/