1. Pre-money valuation
2. Investment amount
3. Option Pool creation
4. Liquidation Preference
5. Dividends
6. Convertible vs. Participating Preferred Stock

Negotiating all of these terms in parallel is the suggested method, as all of them together influence the complete valuation.  Let’s take an example…

Example

• $4M investment
• Case 1: $6M pre-money valuation with a 15% option pool created from the pre-money side
• Case 2: $4.5M pre-money valuation with a 15% option pool created from the post-money side
• Both result in the same shares and % ownerships for the investor and entrepreneur.

By understanding each of the these individual levers it is possible to understand the implications of all of the levers acting together.  In the future, we will provide a more complete perspective into all of the levers

Let’s look at the example shown on the right. First, let’s take the initial exit amount at $15M. In this example, everyone walks away with some money. Now, change the exit amount from $15M to $5M (just enter and hit return). First off, you may notice is that the Convertible Preferred stock is no longer converting to common. Instead, it is staying as preferred during the exit. Also the liquidation stack takes over, and you see that the last investor (VC2) walks away with all $2M of their initial investment as this was a 1x liquidation preference. The first investor (VC1) only receives $3M of their original $4M investment. Last, you’ll notice that the founders receive $0.

In this example, the seniority of the liquidation stack was on the last money-in. You can edit the exit amount and see various scenarios for what happens with the liquidation stack.

Illustrated on the right is the difference for methods used to create an option pool. In both pie charts, you’ll notice that the option pool size is 10%, as this is computed on a post-money basis (after the investment). On the top is the option pool created from the pre-money side. As the Investor bought 40% the company ($2M investment on a $3M pre-money valuation), that leaves 60% for the founder and option pool. Since the option pool accounts for 10%, logically the founder own’s 50% of the company. In the bottom the option pool is created from the post-money side, which dilutes both the founder and investor. Before the option pool, the founder owned 60% while the investor owned 40%. Dilution to both sides is based on the 60/40 ratio. Therefore, the founder goes from 60% ownership to 54%. The investor goes from 40% to 36%.

The equations are shown for these two situations. Please note that you can update the values and watch the equations solve for other values as you desire.

The example to the right illustrates how each type of preferred stock behaves given the same exit event. Participating will always give a higher return to the investor than convertible. Try some different exit values to see how each type of stock behaves.

Let’s take an example. The increased number of fields with our illustration reflects how timing now enters into the equation. With dividends, how long they have been accumulating interest is critical, so we’ve added the dates to the right. The impact in this example with only two years of non cumulative dividends is an additional 8% of the proceeds ($2M x 10% x 2 years = $400k) going to the investors.

Even more dramatic is when the liquidation preference is increased from 1x to 2x. In this case, the liquidation preference is $4M with the dividends accumulating on this $4M amount ($4M x 10% x 2 years = $800k).

We see on the right the two scenarios.  The top chart shows the proceeds for the investor and founders if the investors put their money into common stock (where no liquidation preference exists).  The chart below shows if the stock was Convertible Preferred Stock with a liquidation preference of 2x.  With an exit amount of $5M, the 2x liquidation preference means that the investors receive 2x their initial investment of $2M for a total of $4M, before any money is provided to common shareholders.  Therefore, the founders only receive $1M (the remaining money) of the $5M exit amount (thus 20%). 

It is possible to try out different scenarios with the example to the right. Keep in mind, that the behavior of Convertible Preferred Stock is:

1. to not convert to common, which means the liquidation preference is taken or
2. convert to common and ignore the liquidation preference.

To see a scenario where the investor converts to common, set the Exit Amount to $12,100,000.  At this point, the investor converts to common to receive 33.33% of the $12,100,000 exit instead of the 2x liquidation preference yielding $4,000,000.  Up until $12,000,000, the investor will stay as preferred and utilize their liquidation preference.  This is an illustration of down-side protection for the investor, which is the reason that liquidation preference exists.

“Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.  The term “Employee Pool” shall include both shares reserved for issuance as stated above, as well as current options outstanding, which aggregate amount is approximately __% of the Company’s fully diluted capital stock following the issuance of its Series A Preferred.”

The employee pool section is a separate section in order to clarify the capital structure and specifically call out the percentage of the company that will be allocated to the option pool associated with the financing.  Since a cap table is almost always included with the term sheet, this section is redundant, but exists so there is no confusion about the size of the option pool.

When Jason and I last wrote on the mythical term sheet, we were working our way through the terms that “can matter.” The last one on our list is vesting, and we approach it with one eyebrow raised understanding the impact of this term is crucial for all founders of an early stage company.

While vesting is a simple concept, it can have profound and unexpected implications. Typically, stock and options will vest over four years – which means that you have to be around for four years to own all of your stock or options (for the rest of this post, I’ll simply refer to the equity as “stock” although exactly the same logic applies to options.) If you leave the company earlier than the four year period, the vesting formula applies and you only get a percentage of your stock. As a result, many entrepreneurs view vesting as a way for VCs to “control them, their involvement, and their ownership in a company” which, while it can be true, is only a part of the story.

A typical stock vesting clause looks as follows:

Stock Vesting: All stock and stock equivalents issued after the Closing to employees, directors, consultants and other service providers will be subject to vesting provisions below unless different vesting is approved by the majority (including at least one director designated by the Investors) consent of the Board of Directors (the “Required Approval”): 25% to vest at the end of the first year following such issuance, with the remaining 75% to vest monthly over the next three years. The repurchase option shall provide that upon termination of the employment of the shareholder, with or without cause, the Company or its assignee (to the extent permissible under applicable securities law qualification) retains the option to repurchase at the lower of cost or the current fair market value any unvested shares held by such shareholder. Any issuance of shares in excess of the Employee Pool not approved by the Required Approval will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the Investors’ first offer rights.

The outstanding Common Stock currently held by _________ and ___________ (the “Founders”) will be subject to similar vesting terms provided that the Founders shall be credited with [one year] of vesting as of the Closing, with their remaining unvested shares to vest monthly over three years.

Industry standard vesting for early stage companies is a one year cliff and monthly thereafter for a total of 4 years. This means that if you leave before the first year is up, you don’t vest any of your stock. After a year, you have vested 25% (that’s the “cliff”). Then – you begin vesting monthly (or quarterly, or annually) over the remaining period. So – if you have a monthly vest with a one year cliff and you leave the company after 18 months, you’ll have vested 37.25% of your stock.

Often, founders will get somewhat different vesting provisions than the balance of the employee base. A common term is the second paragraph above, where the founders receive one year of vesting credit at the closing and then vest the balance of their stock over the remaining 36 months. This type of vesting arrangement is typical in cases where the founders have started the company a year or more earlier then the VC investment and want to get some credit for existing time served.

Unvested stock typically “disappears into the ether” when someone leaves the company. The equity doesn’t get reallocated – rather it gets “reabsorbed” – and everyone (VCs, stock, and option holders) all benefit ratably from the increase in ownership (or – more literally – the reverse dilution.”) In the case of founders stock, the unvested stuff just vanishes. In the case of unvested employee options, it usually goes back into the option pool to be reissued to future employees.

A key component of vesting is defining what happens (if anything) to vesting schedules upon a merger. “Single trigger” acceleration refers to automatic accelerated vesting upon a merger. “Double trigger” refers to two events needing to take place before accelerated vesting (e.g., a merger plus the act of being fired by the acquiring company.) Double trigger is much more common than single trigger. Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to “get all their stock in a transaction – hey, we earned it!” and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price. Most acquires will want there to be some forward looking incentive for founders, management, and employees, so they usually either prefer some unvested equity (to help incent folks to stick around for a period of time post acquisition) or they’ll include a separate management retention incentive as part of the deal value, which comes off the top, reducing the consideration that gets allocated to the equity ownership in the company. This often frustrates VCs (yeah – I hear you chuckling “haha – so what?”) since it puts them at cross-purposes with management in the M&A negotiation (everyone should be negotiating to maximize the value for all shareholders, not just specifically for themselves.) Although the actual legal language is not very interesting, it is included below.

In the event of a merger, consolidation, sale of assets or other change of control of the Company and should an Employee be terminated without cause within one year after such event, such person shall be entitled to [one year] of additional vesting. Other than the foregoing, there shall be no accelerated vesting in any event.”

Structuring acceleration on change of control terms used to be a huge deal in the 1990′s when “pooling of interests” was an accepted form of accounting treatment as there were significant constraints on any modifications to vesting agreements. Pooling was abolished in early 2000 and – under purchase accounting – there is no meaningful accounting impact in a merger of changing the vesting arrangements (including accelerating vesting). As a result, we usually recommend a balanced approach to acceleration (double trigger, one year acceleration) and recognize that in an M&A transaction, this will often be negotiated by all parties. Recognize that many VCs have a distinct point of view on this (e.g. some folks will NEVER do a deal with single trigger acceleration; some folks don’t care one way or the other) – make sure you are not negotiating against and “point of principle” on this one as VCs will often say “that’s how it is an we won’t do anything different.”

Recognize that vesting works for the founders as well as the VCs. I’ve been involved in a number of situations where one or more founders didn’t work out and the other founders wanted them to leave the company. If there had been no vesting provisions, the person who didn’t make it would have walked away with all their stock and the remaining founders would have had no differential ownership going forward. By vesting each founder, there is a clear incentive to work your hardest and participate constructively in the team, beyond the elusive founders “moral imperative.” Obviously, the same rule applies to employees – since equity is compensation and should be earned over time, vesting is the mechanism to insure the equity is earned over time.

Of course, time has a huge impact on the relevancy of vesting. In the late 1990′s, when companies often reached an exit event within two years of being founded, the vesting provisions – especially acceleration clauses – mattered a huge amount to the founders. Today – as we are back in a normal market where the typical gestation period of an early stage company is five to seven years, most people (especially founders and early employees) that stay with a company will be fully (or mostly) vested at the time of an exit event.

While it’s easy to set vesting up as a contentious issue between founders and VCs, we recommend the founding entrepreneurs view vesting as an overall “alignment tool” – for themselves, their co-founders, early employees, and future employees. Anyone who has experienced an unfair vesting situation will have strong feelings about it – we believe fairness, a balanced approach, and consistency is the key to making vesting provisions work long term in a company.

As I watched 24 last night, I kept thinking to myself “Why the fuck does Jack have his cell phone ringer on – hasn’t he ever heard of vibrate?” immediately after his cell phone rang but right before he got shot at because the bad guys now knew where he was. I had a parallel thought this morning – “Why do we make all this term sheet stuff so long, verbose, and tedious.” The answer – word processers. If we had to type all this crap on a typewriter (or write it out by hand) it’d be a lot shorter. In both cases, technology is working against us. But – then again, we wouldn’t have blogs (and I can hear a few of you (and I know who you are) saying “and that would be a bad thing because?”)

While there is a lot to negotiate in a term sheet (as you can see from the series ofposts on term sheets that Jason and I have written), a term sheet is simply a step on the way to an actual deal. Term sheets are often either non-binding (or mostly non-binding), and most investors will load them up with conditions precedent to financing. Entrepreneurs glance over these – usually because they are in the back sections of the term sheet and are typically pretty innocuous, but they occasionally have additional “back door outs” for the investor that the entrepreneur should watch out for, if only to better understand the current mindset of the investor proposing the investment.

A typical conditions precedent to financing clause looks as follows:

“Conditions Precedent to Financing: Except for the provisions contained herein entitled “Legal Fees and Expenses”, “No Shop Agreement”, and “Governing Law” which are explicitly agreed by the Investors and the Company to be binding upon execution of this term sheet, this summary of terms is not intended as a legally binding commitment by the Investors, and any obligation on the part of the Investors is subject to the following conditions precedent: 1. Completion of legal documentation satisfactory to the prospective Investors; 2. Satisfactory completion of due diligence by the prospective Investors; 3. Delivery of a customary management rights letter to Investors; and 4. Submission of detailed budget for the following twelve months, acceptable to Investors.”

Notice that the investor will try to make a few things binding – specifically (a) that his legal fees get paid whether or not a deal happens, (b) that the company can’t shop the deal once the term sheet is signed, and (c) that the governing law be set to a specific domicile – while explicitly stating “there are a bunch things that still have to happen before this deal is done and I can back out for any reason.”

There are a few conditions to watch out for since they usually signal something non-obvious on the part of the investor. They are:

1. “Approval by Investors’ partnerships” – this is super secret VC code for “this deal has not been approved by the investors who issued this term sheet. Therefore, even if you love the terms of the deal, you still may not have a deal.

2. “Rights offering to be completed by Company” – this indicates that the investors want the company to offer all previous investors in the company the ability to participate in the currently contemplated financing. This is not necessarily a bad thing – in fact in most cases this serves to protect all parties from liability – but does add time and expense to the deal.

3. “Employment Agreements signed by founders as acceptable to investors” – beware what the full terms are before signing the agreement. As an entrepreneur, when faced with this, it’s probably wise to understand (and negotiate) the form of employment agreement early in the process. While you’ll want to try to do this before you sign a term sheet and accept a no-shop, most VCs will wave you off and say “don’t worry about it – we’ll come up with something that works for everyone.”  Our suggestion – at the minimum, make sure you understand the key terms (such as compensation and what happens on termination).

There are plenty of other wacky conditionals – if you can dream it, it has probably been done. Just make sure to look carefully at this paragraph and remember that just because you’ve signed a term sheet, you don’t have a deal.

As our term sheet series unfolds (almost as exciting as 24, eh? – if you’ve been reading the last few days I bet you figured out that I recently had a 7 hour plane ride with a laptop battery that was in pretty good shape) we now shift gears from nuclear meltdown situations (also known as “things that matter a lot”) to economic terms that can matter, but aren’t as important (e.g. “why doesn’t Kim have a job at CTU anymore?”)

Dividends are up first. While private equity guys love dividends (e.g. I guarantee you that when Bain Capital buys the NHL and renames it the “BHL”, the deal will have dividends in it), many venture capitalists – especially early stage ones – don’t really care about dividends (although some do – especially those that come from a pure financial focus and have never had a 50x+ return on anything). Typical dividend language in a term sheet follows:

“Dividends: The holders of the Series A Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of Series A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.”

For early stage investments, dividends generally do not provide “venture returns” – they are simply modest juice in a deal. Let’s do some simple math. Assume a typical dividend of 10% (dividends will range from 5% to 15% depending on how aggressive your investor is – we picked 10% to make the math easy). Now – assume that you are an early stage VC (painful and yucky – we understand – just try for a few minutes). Success is not a 10% return – success is a 10x return. Now, assume that you (as the VC) have negotiated hard and gotten a 10% cumulative (you get the dividend every year, not only when they are declared), automatic (they don’t have to be declared, they happen automatically), annual dividend. Again – to keep the math simple – let’s assume the dividend does not compound – so every year you simply get 10% of your investment as a dividend. In this case, it will take you 100 years to get your 10x return. Since a typical venture deal lasts 5 to 7 years (and you’ll be dead in 100 years anyway), you’ll never see the 10x return from the dividend.

Now – assume a home run deal – assume a 50x return on a $10m investment in five years. Even with a 10% cumulative annual dividend, this only increases the investor return from $500m to $505m (the annual dividend is $1m (10% of $10m) times 5 years).

So – while the juice from the dividend is nice, it doesn’t really move the meter in the success case – especially since venture funds are typically 10 years long – meaning as a VC you’ll only get 1x your money in a dividend if you invest on day 1 of a fund and hold the investment for 10 years. (NB to budding early stage VCs – don’t raise your fund on the basis of your future dividend stream from your investments).

This also assumes the company can actually pay out the dividend – often the dividends can be paid in either stock or cash – usually at the option of the company. Obviously, the dividend could drive additional dilution if it is paid out in stock, so this is the one case where it is important not to get head faked by the investor (e.g. the dividend simply becomes another form of anti-dilution protection – although in this case one that is automatic and simply linked to the passage of time).

Of course – we’re being optimistic about the return scenarios. In downside cases, the juice can matter, especially as the invested capital increases. For example, take a $40m investment with a 10% annual cumulative dividend in a company that was sold at the end of the fifth year to another company for $80m. In this case, assume that there was a straight liquidation preference (e.g. no participating preferred) and the investor got 40% of the company for her investment (or a $100m post money valuation). Since the sale price was below the investment post money valuation (e.g. a loser, but not a disaster), the investor will exercise the liquidation preference and take the $40m plus the dividend ($4m per year for 5 years – or $20m). In this case, the difference between the return in a no dividend scenario ($40m) and a dividend scenario ($60m) is material.

Mathematically, the larger the investment amount and the lower the expected exit multiple, the more the dividend matters. This is why you see dividends in private equity and buyout deals, where big money is involved (typically greater than $50m) and the expectation for return multiples on invested capital are lower.

Automatic dividends have some nasty side effects, especially if the company runs into trouble, as they typically should be included in the solvency analysis and – if you aren’t paying attention – an automatic cumulative dividend can put you unknowingly into the zone of insolvency (a bad place – definitely one of Dante’s levels – but that’s for another post).

Cumulative dividends can also annoying and often an accounting nightmare, especially when they are optionally in stock, cash, or a conversion adjustment, but that’s why the accountants get paid the big bucks at the end of the year to put together the audited balance sheet.

That said, the non-cumulative when declared by the board dividend is benign, rarely declared, and an artifact of the past, so we typically leave it in term sheets just to give the lawyers something to do.