Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway. – Warren Buffett
So the big day is here. You have evangelized your product across various circles and the good news is that a VC has stepped forward to invest in your company. So the hard work is all done! You can rest on your laurels, sign the term sheet that the VC has pushed across the table, and execute the sheet, trigger the stock purchase, voter and investor rights agreements, get the wire and you are up and running! Wait … sounds too good to be true, doesn’t it? And yes you are right! If only things were that easy. The devil is in the details. So let us go over some of the details that you need to watch out for.
1. First, term sheet does not trigger the wire. Signing a term sheet does not mean that the VC will invest in your company. The road is still long and treacherous. All the term sheet does is that it requires you to keep silent on the negotiations, and may even prevent you to shop the deal to anyone else. The key investment terms are laid out in the sheet and would be used in much greater detail when the stock purchase agreement, the investor rights agreement, the voting agreement and other documents are crafted.
2. Make sure that you have an attorney representing you. And more importantly, an attorney that has experience in the field and has reviewed a lot of such documents. As noted, the devil is in the details. A little “and” or “or” can put you back significantly. But it is just as important for you to know some of the key elements that govern an investment agreement. You can quiz your attorney on these because some of these are important enough to impact your operating degree of freedom in the company.The starting point of a term sheet is valuation of the company. You will hear the concept of pre-money valuation vs. post-money valuation. It is quite simple. The Pre-Money Valuation + Investment = Post-Money Valuation. In other words, Pre-money valuation refers to the value of a company not including external funding or the latest round of funding. Post-Money thus includes the pre-money plus the incremental injection of capital. Let us look at an example:
Let’s explain the difference by using an example. Suppose that an investor is looking to invest in a start up. Both parties agree that the company is worth $1 million and the investor will put in $250,000.
The ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation. If the $1 million valuation is pre-money, the company is valued at $1 million before the investment and after investment will be valued at $1.25 million. If the $1 million valuation takes into consideration the $250,000 investment, it is referred to as post-money. Thus in a pre-money valuation, the Investor owns 20%. Why? The total valuation is $1.25M which is $1M pre-money + $250K capital. So the math translates to $250K/$1,250K = 20%. If the investor says that they will value company $1M post-money, what they are saying is that they are actually giving you a pre-money valuation of $750K. In other words, they will own 25% of the company rather than 20%. Your ownership rights go down by 5% which, for all intents and purposes, is significant.
3. When a round of financing is done, security is exchanged in lieu of cash received. You already have common stock but these are not the securities being exchanged. The company would issue preferred stock. Preferred stock comes with certain rights, preferences, privileges and covenants. Compared to common stock, it is a superior security. There are a number of important rights and privileges that investors secure via a preferred stock purchase, including a right to a board seat, information rights, a right to participate in future rounds to protect their ownership percentage (called a pro-rata right), a right to purchase any common stock that might come onto the market (called a right of first refusal), a right to participate alongside any common stock that might get sold (called a co-sale right), and an adjustment in the purchase price to reflect sales of stock at lower prices (called an anti-dilution right). Let us examine this in greater detail now. There are two types of preferred. The regular vanilla Convertible Preferred and the Participating Preferred. As the latter name suggests, the Participating Preferred allows the VC to receive back their invested capital and the cumulative dividends, if any before common stockholders (that is you), but also enables them to participate on an as-converted basis in the returns to you, the common stockholder. Here is the math:Let us say company raises $3M at a $3M pre-money valuation. As mentioned before in point (3), the stake is 50%-50% owner-investor.
Let us say company sells for $25M. Now the investor has participating preferred or convertible preferred. How does the difference impact you, the stockholder or the founder. Here goes!
i. Participating Preferred. Investor gets their $3M back. There is still $22M left in the coffers. Investor splits 50-50 based on their participating preferred. You and Investor both take home $11M from the residual pool. Investor has $14M, and you have $11M. Congrats!
ii. Convertible Preferred. Investor gets 50% or $12.5M and you get the same – $12.5M. In other words, convertible preferred just got you a few more drinks at the bar. Hearty Congratulations!
Bear in mind that if the Exit Value is lower, the difference becomes more meaningful. Let us say exit was $10M. The Preferred participant gets $3M + $3.5M = $6.5M while you end up with $3.5M.
4. One of the key provisions is Liquidation Preferences. It can be a ticking time bomb. Careful! Some investors may sometimes ask for a multiple of their investment as a preference. This provision provides downside protection to investors. In the event of liquidation, the company has to pay back the capital injected for preferred. This would mean a 1X liquidation preference. However, you can have a 2X liquidation preference which means the investor will get back twice as much as what they injected. Most liquidation preferences range from 1X to 2X, although you can have higher liquidation preference multiples as well. However, bear in mind that this becomes important only when the company is forced to liquidate and sell of their assets. If all is gung-ho, this is a silent clause and no sweat off your brow.
5. Redemption rights. The right of redemption is the right to demand under certain conditions that the company buys back its own shares from its investors at a fixed price. This right may be included to require a company to buy back its shares if there has not been an exit within a pre-determined period. Failure to redeem shares when requested might result in the investors gaining improved rights, such as enhanced voting rights.
6. The terms could demand that a certain option pool or a pot of stock is kept aside for existing and future employees, or other service providers. It could be a range anywhere between 10-20% of the total stock. When you reserve this pool, you are cutting into your ownership stake. In those instances when you have series of financings and each financing requires you to set aside a small pool, it dilutes you and your previous investors. In general, the way these pools are structured is to give you some headroom up to at least 24 months to accommodate employee growth and providing them incentives. The pool only becomes smaller with the passage of time.
7. Another term is the Anti-Dilution Provision. In its simplest form, anti-dilution rights are a zero- sum game. No one has an advantage over the other. However, this becomes important only when there is a down round. A down round basically means that the company is valued lower in subsequent financing than previously. A company valued at $25M in Series A and $15M in Series B – the Series B would be considered a down round. Two Types of Anti-Dilution:
Full ratchet Anti-Dilution: If the new stock is priced lower than prior stock, the early investor has a clause to convert their shares to the new price. For example, if prior investor paid $1.00 and then it was reset in a later round to $0.50, then the prior investors will have 2X rights to common stock. In other words, you are hit with major dilution as are the later investors. This clause is a big hurdle for new investors.
Weighted Average Anti-Dilution. Old investor’s share is adjusted in proportion to the dilution impact of a down round
8. Pay to Play. These are clauses that work in your, the Company, favor. Basically, investors have to invest some money in later financings, and if they do not – their rights may be reduced. However, having these clauses may put your mind at ease, but may create problems in terms of syndicating or getting investments. Some investors are reluctant to put their money in when there are pay to play clauses in the agreement.
9. Right of First Refusal. A company has no obligation to sell stock in future financing rounds to existing investors. Some investors would like to participate and may seek pro-rata participating to keep their ownership stake the same post-financing. Some investors may even want super pro-rata rights which means that they be allowed to participate to such an extent that their new ownership in the company is greater than their previous ownership stake.
10. Board of Directors. A large board creates complexity. Preferable to have a small but strategic board. New investors will require some representation. If too many investors request representation, the Company may have smaller internal representatives and may be outvoted on certain issues. Be aware of the dynamics of a mushrooming board!
11.Voting Rights. Investors may request certain veto authority or have rights to vote in favor of or against a corporate initiative. Company founders may want super-voting rights to exercise greater control. These matters are delicate and going one way or the other may cause personal issues among the participants. However, these matters can be easily resolved by essentially having carve-outs that spell out rights and encumbrances.
12.Drag Along Provision. Might create an obligation on all shareholders of the company to sell their shares to a potential purchaser if a certain percentage of the shareholders (or of a specific class of shareholders) votes to sell to that purchaser. Often in early rounds drag along rights can only be enforced with the consent of those holding at least a majority of the shares held by investors. These rights can be useful in the context of a sale where potential purchasers will want to acquire 100% of the shares of the company in order to avoid having responsibilities to minority shareholders after the acquisition. Many jurisdictions provide for such a process, usually when a third party has acquired at least 90% of the shares.
13.Representations and Warranties. Venture capital investors expect appropriate representations and warranties to be provided by key founders, management and the company. The primary purpose of the representations and warranties is to provide the investors with a complete and accurate understanding of the current condition of the company and its past history so that the investors can evaluate the risks of investing in the company prior to subscribing for their shares. The representations and warranties will typically cover areas such as the legal existence of the company (including all share capital details), the company’s financial statements, the business plan, asset ownership (in particular intellectual property rights), liabilities (contingent or otherwise), material contracts, employees and litigation. It is very rare that a company is in a perfect state. The warrantors have the opportunity to set out issues which ought to be brought to the attention of the new investors through a disclosure letter or schedule of exceptions. This is usually provided by the warrantors and discloses detailed information concerning any exceptions to or carve-outs from the representations and warranties. If a matter is referred to in the disclosure letter the investors are deemed to have notice of it and will not be able to claim for breach of warranty in respect of that matter. Investors expect those providing representations and warranties about the company to reimburse the investors for the diminution in share value attributable to the representations and warranties being inaccurate or if there are exceptions to them that have not been fully disclosed. There are usually limits to the exposure of the warrantors (i.e. a dollar cap on the amount that can be recovered from individual warrantors). These are matters for negotiation when documentation is being finalized. The limits may vary according to the severity of the breach, the size of the investment and the financial resources of the warrantors. The limits which typically apply to founders are lower than for the company itself (where the company limit will typically be the sum invested or that sum plus a minimum return).
14. Information Rights. In order for venture capital investors to monitor the condition of their investment, it is essential that the company provides them with certain regular updates concerning its financial condition and budgets, as well as a general right to visit the company and examine its books and records. This sometimes includes direct access to the company’s auditors and bankers. These contractually defined obligations typically include timely transmittal of annual financial statements (including audit requirements, if applicable), annual budgets, and audited monthly and quarterly financial statements.
15. Exit. Venture capital investors want to see a path from their investment in the company leading to an exit, most often in the form of a disposal of their shares following an IPO or by participating in a sale. Sometimes the threshold for a liquidity event or will be a qualified exit. If used, it will mean that a liquidity event will only occur, and conversion of preferred shares will only be compulsory, if an IPO falls within the definition of a qualified exit. A qualified exit is usually defined as a sale or IPO on a recognized investment exchange which, in either case, is of a certain value to ensure the investors get a minimum return on their investment. Consequently, investors usually require undertakings from the company and other shareholders that they will endeavor to achieve an appropriate share listing or trade sale within a limited period of time (typically anywhere between 3 and 7 years depending on the stage of investment and the maturity of the company). If such an exit is not achieved, investors often build in structures which will allow them to withdraw some or the entire amount of their investment.
16. Non-Compete, Confidentiality Agreements. It is good practice for any company to have certain types of agreements in place with its employees. For technology start-ups, these generally include Confidentiality Agreements (to protect against loss of company trade secrets, know-how, customer lists, and other potentially sensitive information), Intellectual Property Assignment Agreements (to ensure that intellectual property developed by academic institutions or by employees before they were employed by the company will belong to the company) and Employment Contracts or Consultancy Agreements (which will include provisions to ensure that all intellectual property developed by a company’s employees belongs to the company). Where the company is a spin-out from an academic institution, the founders will frequently be consultants of the company and continue to be employees of the academic institution, at least until the company is more established. Investors also seek to have key founders and managers enter into Non-compete Agreements with the company. In most cases, the investment in the company is based largely on the value of the technology and management experience of the management team and founders. If they were to leave the company to create or work for a competitor, this could significantly affect the company’s value. Investors normally require that these agreements be included in the Investment Agreement as well as in the Employment/Consultancy Agreements with the founders and senior managers, to enable them to have a right of direct action against the founders’ and managers if the restrictions are breached.
Convertible Debt is also called convertible loans or convertible notes. This is a common method of financing for early stage companies. Typically, an investor or a group of investors (investor syndicate) extends a loan to a company that could later convert to an equity instrument. Like any debt, it is an interest bearing instrument. However, the key element in this form of financing is that the investors will get equity at a discount when the Company raises a Series A round. In other cases, it could be a warrant issue. In most instances, there is a cap on the valuation at which the debt will convert.
Hence, there are four key components of convertible debt:
- Convertible Debt has an interest.
- Convertible Debt has a discount
- Convertible Debt may have warrants
- Valuation at which Debt converts is capped.
Let us discuss each of these in detail.
Convertible Debt is interest bearing.
Like any debt, the borrower has a loan on their balance sheet. They are responsible for the principal and the interest. The interest is simple interest rate, and there is a fixed due date (or “maturity date”) for repayment of the amount borrowed. In other words, if there is no Series A funding before the maturity of the convertible debt, there could be some problems for the company. In an extreme case, the note holder can force the company into bankruptcy, unless the startup can renegotiate and extend the terms. The appropriate interest rate for convertible debt could be anywhere between 6% up to 10%. The Applicable Federal Rates (AFRs) can establish the lowest legally allowable interest rates.
Convertible Note Discount.
As a sweetener, the note will have an automatic conversion discount feature by which the investor will exchange the convertible debt for shares of a Series A Preferred Stock at a discount to the price per share paid by a VC in a Qualified Financing Round. Here is how this works:
A) Angel invests $100,000 in the startup company.
B) Startup issues the convertible note for $100K which has an interest and maturity date.
C) The Note has an automatic conversion feature at $1M with a conversion discount equal to 20%.
D) Now, let us say that the Startup closes $1M Series A Preferred Stock at $1 per share.
E) The Angel thus gets the shares at 80 cents.
F) So Angel gets $100,000/$0.80 per share of the Series A Preferred which totals to 125,000 shares.
Convertible Notes may have warrants.
The warrants are very similar to options. In a typical convertible note, the Warrant will be an option for whatever security is sold in the next round. It is often expressed in terms of “warrant coverage percentage”. A 20% warrant coverage means that you can take the same $1M, multiply by 20%, and the Warrant independently will enable you to get $200K of additional securities in the next round. For example, let us say a Series A round is $4M (Company has raised $4M). The warrant coverage kicks in and now the size of the round becomes $5.2M. ($4M New Fund + $1M size of Note + $200K warrant coverage = $5.2M) So there is a dilution impact of $1.2M for the $1M of angel cash that was extended in the form of the Note with the Warrant Coverage.
Convertible Notes Caps
Cap is a term that protects the angel investor and puts a ceiling on the conversion price of debt. This is seen mostly in seed financings. For example, angel invests a $100K in a company at 20% discount and thinks that the pre-money valuation maxes out at $3M. If the angel was correct and the valuation was indeed at $3M (assume $1.00 for preferred share) , then the angel would have 125,000 shares. That would be 125,000 shares/(3M shares + 125,000) = 4%. The investor would own 4% immediately upon Qualified Financing.
However, assume that the company is hugely successful and the pre-money valuation is assessed at $10M. Let us say that the preferred stock is at $1.00. So now you have 10M shares. Angel Investor gets 125,000 shares. Then the Investor is diluted down to 1.23%. (125K shares/ (10M shares + 125K shares)). Hence the higher the valuation in Series A, the investor gets diluted down further. Hence they use Convertible Notes Caps as a protection to their downside dilution risk. The cap sets a limit for how much the Company can raise before the investor’s shares stop getting diluted. It sets an upper limit. So if the investor in the above example sets a cap at $5M, then the discount would increase to offset the additional dilution that occurred. So in this case, the investor actually gets a 50% discount, not a 20% discount. It is important to note that the cap is structured as either or – in other words, the angel investor gets the value of the greater of the two discounts.
Advantages of Convertible Debt Financing
- Easy to raise
- Paperwork could be less than 10 pages.
- Quick turnaround time to get this signed off
- Terms are generally clearly defined
- Legal Expenses are typically less than $5000-$8000.
- Company can defer the valuation discussion until a later date
- Notes have fewer rights than Equity. Investors in Notes have less say in the direction and execution of company plans.
Disadvantages of Convertible Debt Financing
- It is a loan and there is a maturity date on the loan. If financing does not occur, the investor can recall the note and force the company into bankruptcy.
- Incentives are not necessarily aligned. Company wants more valuation in Series A but investor would want less to own larger pool. With a cap, they accomplish that but the Company owners are diluted down depending on cap or size of discount.
- Size of discount or cap could create problems for the Company seeking Series A. Series A investors might force a renegotiation thus increasing legal and other costs to the Company. A low valuation cap could adversely affect the owners of the Company.
- Conversion to equity would mean equivalent privileges with respect to rights. Bear in mind that angel investors are generally not professional VC’s and each of them have very different expertise. Equivalent rights for the different expertise may create problems and issues among all parties involved.
- Convertible Notes may have senior preferences. In the event of liquidation, the Note Holders are first in line to get their money back.
- Some angel investors may want subscription rights or super pro-rata rights to the next round of funding. This is to prevent their dilution. So they may want to have the option to participate up to a certain percentage of the next round. In other words, if the round is $5M, the subscription right might specify that the investor can participate up to 30% and that would mean that the investor has a bigger seat on the table. Such clauses may not be favorably looked at by Series A investor and these clauses could hold up financing.