Valuation, ESOP, Liquidation Preference, Dilution. Guide to Term Sheets
This is the first part of a series of articles dedicated to Term Sheets. For other posts please follow the links below:
- Valuation, ESOP, Liquidation Preference, Dilution. Guide to Term Sheets
- Shares, Protective Provisions, BoD. Guide to Terms Sheets, Part 2
- Investor rights. Guide to Term Sheets. Part 3
Many entrepreneurs think that the startup financing process is somewhat straightforward. They believe that following the company’s pitch and Q&A they would have an investor come back with either “YES” or “NO”. In reality, the financing process can take up to six to nine months. When negotiations are ended, it’s time to review a “Term Sheet” received from a potential investor.
Term sheet — is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made.
After an investor expressed an interest in putting money into a start-up company verbally, founders shall be extremely cautious during papers exchange with an investor. It’s important to pay attention to each section in each document, otherwise, founders risk being trapped in undesirable corporate relationships with its own investors — future company shareholders.
Below I list some of the most important sections of a term sheet, which I recommend paying particular attention to.
First part includes the economics of a deal. Any oversight here could hit founders in their pockets.
Tips for negotiations over valuation
Let’s imagine an investor approaches a founder with the following statement: “I am ready to invest $2M at a $8M valuation” — which equity share will the investor get for proposed $2M? It seems that the answer can be either 25% or 20%
Here we need to introduce the notion of a pre-money and post-money valuation. (if you are already familiar with these terms, please scroll down to the next “ESOP” section)
As you can imagine, 25% for $2M investment is a fairly desired outcome for an investor. Why? Because in this case, $8M mentioned above is a post-money valuation — meaning the value of the company after an investment has been made.
On the other hand, if we consider proposed $8M as a pre-money valuation (value of a company prior to financing), then upon $2M investment, an investor will get 20% of target company shares. In this case, the post-money valuation will amount to $10M.
As a result, the company valuation can be calculated in two ways: pre- and post-financing. Below is a visual representation of how post-money valuation builds up.
Practical tip: always use “pre-money” when discussing your company valuation — by doing so you will avoid misunderstandings and undesired outcomes.
Having said that, sometimes negotiating parties can not agree on a mutually appropriate valuation figure. In this situation, there is a number of other mechanisms to structure an investment deal, one of the most popular ones is called “Convertible Loan”, which sets the maximum price at which the investment made via the convertible loan can convert into equity in the subsequent financing rounds. (for the details about convertible loans please read in my blog post here)
Tips for negotiations over ESOP
ESOP (Employee stock option pool) — is an employee benefit plan that gives workers ownership interest in the company. ESOPs encourage employees to do what’s best for the company and shareholders since the employees themselves are shareholders. ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them or putting cash in to buy existing company shares.
ESOP pools are typically issued in favour of key personnel at the Seed/Series A financing rounds and is re-evaluated during all next liquidity events.
Coming back to our case presented above, an investor negotiated to put $2M for 20% of your company and demanded a 10% ESOP. Now the question will be whether to issue the ESOP pre- or post raise? Below are the calculations for both scenarios:
Scenario 1: ESOP issued pre-raise. In this instance, post-investment, the cap table will look as follows:
- investor holds 20%,
- founders are diluted down to 72%,
- ESOP pool is diluted down to 8%,
- $7.2M pre-money valuation of the round
Scenario 2: ESOP issued post-raise. This is more favourable for the founders and existing shareholders. The new cap table post-investment will be as follows:
- Investor is diluted down to 18%,
- founders are diluted down to 72%,
- ESOP pool equals to 10%,
- $9.1M pre-money valuation of the round
Practical tip: always agree on ESOP terms in advance and prepare hiring plan diligently in order to have a strong position during negotiation over ESOP pool required size.
Tips for negotiations over liquidation preferences
The liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation. It determines who gets first and how much when the company is liquidated, sold, or declares bankruptcy.
For instance, the company gets an investment in the amount of $2M at a $6M pre-money. Hence, the investor gets 25% of the company, while founders are diluted to 75%. At some point later the company is sold for $20M. From now on, there might be 3 possible scenarios when it comes to liquidation preference conditions:
- Scenario 1. Non-participation liquidation preferences. In this scenario, the investor and founders get pro-rata payment upon exit. In our case, the investor gets $5M and the founders enjoy $15M check respectively.
- Scenario 2. Participation liquidation preferences. In this scenario, investors get all their invested money first, while the remaining amount is split between founders and investors according to their ownership shares. Thereby, in our case, the investor gets $2M + 25% of $18M = $6.5M, while founders get 75% of $18M = $13.5M.
- Scenario 2.1. Liquidation multiple. This means that investors will get their invested money back first multiplied by X times before any other shareholder gets a penny.
Practical tip: it’s important to pay attention to this section especially after several investment rounds are completed.
For more information about Liquidation Preferences please read my next article here (coming soon)
Tips for negotiations over protection against dilution
In an ideal world, a startup company raises subsequent financing rounds at the increased valuation. Founders get their equity shares diluted, but their respective monetary value grows. However, at times companies raise their funding round at the valuation lower than during the preceding one. In such a case, it is important to have dilution protection terms fixed in a term sheet.
When a company succeeds in raising its next funding round at the higher valuation vs previous round, the only thing which should bother shareholders is whether they are willing to maintain their equity share or not.
While when a company is raising at a lower valuation vs previous round, the shareholders shall protect themselves with one of the following options:
- Option 1. The investor is diluted in proportion to its share. It’s rather a rare case, way too friendly for founders and other shareholders and pretty negative for the investor.
- Option 2. Full ratchet method. it is an anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders.
- Option 3. Weighted Average Dilution. It’s a compromise option between first and second options.
The attention to detail and timely prevention of issues can avoid most conflicts between shareholders, as well as current and potential investors. Please note that the list above is not complete. We will discuss other sections in the next articles.
You can follow the link below to use our simplified calculator which I used for examples in the article:
We hope this article was helpful to you. We are super keen to hear your comments, feedback or any questions regarding startups financing mechanisms.
Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups across the world and would love to hear from you! You can reach us at leta.vc
