Chapter 6 - Negotiating the Deal
IN THIS LESSON
Term Sheet Glossary
The following are definitions of the terms that are usually used on a term sheet. This document is meant to be a quick reference guide for you when you are negotiating with an investor, particularly a VC. While this glossary is thorough, it is not 100% complete with every term that is ever used.
Anti-dilution
Anti-dilution is a provision that protects investors in case a company tries to issue shares at a lower valuation than what was used in earlier financing rounds.
Anti-dilution provisions generate a conversion price adjustment.
Two varieties of anti-dilution exist:
Ratchet-based anti-dilution – if shares are sold at a lower price in a financing round, then all shares in the earlier round are re-priced to the lower-priced issuance of the current round.
Weighted average anti-dilution – the number of shares issued at the reduced price are considered in the re-pricing of shares from the earlier round of financing
Board of Directors
The Board of Directors is comprised of appointed or elected members who provide governance over the company.
Among the most important things to negotiate a term sheet is overboard seats and board control.
Some experts advise you to build your board of directors early; others say to be cautiously slow giving out board seats.
It is common to build a board that reflects the ownership of the company.
Conversion
Conversion turns preferred stock into common stock.
Usually on a one-to-one basis
Divide the amount invested by the conversion price to get the ratio.
Conversion gets more complicated when IPO rights, drag along and participation caps come into play.
Co-Sale and ROFR
Co-Sale and ROFR refer to the right of an investor to sell stock to the same buyer at the same price and same percentage as a founder sells to; this is designed to be fair to all.
Cost of Counsel
Cost of Counsel are the legal fees that investors expect to be reimbursed back to them; the average amount is between $25k and $75k.
Dividends
Dividends are simply the money that a company pays to its shareholders out of the profits. In early-stage venture capital deals, dividends do not usually come into play.
Drag Along
Drag Along is a provision that makes it possible for most shareholders to force the sale of a company. In essence, most shareholders “drag along” the smaller shareholders, preventing small shareholders from stopping a sale.
The shareholders could all be in the same class or series of stock.
Drag along can be tricky when the company has a substantial minority shareholder base.
Different flavours of drag along
Whose approval is needed to invoke the drag?
This provision can incur high legal costs.
Information Rights
Information Rights give investors the right to company information, such as financial performance and KPIs.
VC are usually adamant about this right.
At times, a company may require a certain number of shares to be purchased to get information rights.
Liquidation Preference
In the event of an unexpected liquidity event (bankruptcy, dissolution, sale at lower-than-expected price, etc), liquidity preference is protection for investors.
Money would go to preferred stockholders prior to going to common shareholders.
Today, liquidation preference is usually 1x.
This is standard. It covers the dollars invested on a one-to-one basis.
VCs almost always want to invest through a “preferred” equity instrument.
You may need to consider if your investors are proposing a “participating” preferred stock, which would mean the investors get their return first but then can continue to participate in the distribution of the remaining funds.
Option Pool
An option pool is equity reserved for future employees.
An option pool can have a dramatic impact on the pre-money valuation; the option pool can lower a company’s effective valuation.
The amount of the option pool should be based on a realistic plan for hiring new employees in the future.
Participation
Participation is an investor-friendly stipulation that allows investors to get their money as a dollar-for-dollar return on their investment but also participate in the distribution of remaining proceeds based on the percentage of their equity-based ownership.
Participation can be “capped”
Shareholders share in the distribution of remaining proceeds until they have received 2x or 4x (a set amount) of the original investment.
It is more common that the “preferred” is non-participating, so the investors do not share in the distribution of remaining proceeds.
Participation Rights
Participation Rights refers to the investor’s right of first refusal to invest in upcoming rounds, typically their pro rata portion of the new financing. This term will be in virtually all VC deals.
Pay to Play
Pay to Play makes it a requirement for investors to invest a certain amount in later rounds; otherwise, they will suffer penalties.
Penalties may include:
Losing some control rights
Losing anti-dilution protection
Forced conversion to common stock.
If a company struggles, Pay to Play can be beneficial to a company.
Occasionally, investors can be become uncomfortable, especially if a lead investor demands this provision.
Pre-Money Valuation
Pre-money valuation is the value that is determined for a company prior to cash being invested.
Pre-money valuations always include a large, unallotted pool of options for new employees.
The option pool is equal to a percentage of the post-financing fully diluted capitalization.
If the option pool is too large, it can reduce the value of each share; thereby reducing the total value of the company. Don’t let the VC set the option pool unabated.
If the option pool turns out to be large, a start-up can negotiate a higher pre-money valuation to offset the impact of the options pool.
Post-Money Valuation
Post-money valuation is comprised of pre-money valuation and total new investment – also known as contemplated aggregate investment amount.
Registration Rights
Registrations Rights refers to the requirement for a company to register investor stock for sale on public markets.
Typically, in every VC deal
Type of Security
Investors usually receive the proceeds of an exit before common stockholders. This is because investors get a type of stock called “preferred stock.”
Voting Rights
Voting Rights give investors a say in approving any actions that could be potentially harmful to them.
Usually, shareholders of a certain class or series of stock require the investors to be involved actions, such as a sale or more financing.
Start-up companies can negotiate “approval thresholds” with investors, so that investors don’t use this right to simply block important company actions.
Warrants
Warrants give investors the right to buy stock at a set price within a set timeframe. The downside of this security / tool is that it can add complexity to a cap table.