Understanding the Investor Term Sheet (Part 1)
9 terms you need to know when raising money for your startup.
As your startup grows and you realize that you need to scale, raising money from investors or VCs is an option to consider. However, it’s important to understand the technicalities of getting investments, and particularly, the term sheet. Here’s what you need to know:
- Issuer: VCs or angel investors will likely issue the term sheet. If there is a more diverse pool of investors, the company will issue the term sheet to coordinate the funding round. Many funding rounds (like Series A, B, and C) may have multiple investors. In this case, the company may issue the term sheet.
- Securities/Type of equity: The type of security offered can be several things, including equity, preferred shares, or warrants. However, in venture capital, this defines the round a company is raising. For example, if a company is raising a Series A round, they would define this as “Series A Preferred Stock.” There are several types or “rounds” of funding. First is a family/friends or angel round, where individual investors have the option of funding a startup. Next is a seed round, when early-stage venture capital companies and more angel investors come into the mix. This is followed by a Series A round, which is usually for companies looking to optimize their product and increase their user base after gaining traction. Series A rounds usually raise $2 million to $15 million. Series B rounds are for further building the company and generally led by the venture capital firms that led the Series A round. Series C and D rounds are generally where institutional and growth equity investors come in to further scale the business. Because the company is less risky at the Series C and D rounds, institutional investors are more ready to invest.
- Pre-money valuation: The worth of the company before investment, which determines how many shares the investor gets upon investing in the company. The valuation is determined by the traction a company has generated, the addressable market, and future revenue projections. At the early stage, it is harder to generate valuations, particularly for pre-revenue companies, due to the lack of financial data. However, it becomes easier to generate valuations as companies grow, gain traction, and generate investments.
- Post-money valuation: The worth of the company after investment, in other words, the pre-money valuation plus the money invested. The post-money valuation after a round will become the pre-money valuation of the next round unless significant events like a large increase in traction affects the valuation.
- Amount of shares: The amount of shares issued is simply the shares being given to investors. For example, if a company is raising $2 million, it would issue 2 million shares of preferred stock. This would give investors proportionate rights to amount they invested. Amount of shares also helps calculate price per share.
- Conversion: Conversion rights are generally issued to those who received preferred stock, or a higher class than common stock due to special rights like voting rights. People who hold preferred stock are given the option to convert to common stock. Mandatory or automatic conversion rights may be used in the case of IPOs or majority votes to ensure the Preferred class can be retired when they get paid. Conversion is calculated using a conversion ratio that generally begins at 1:1 but can be adjusted if there are diluting events like further funding rounds.
- Price Per Share: The “price per share” of the investor term sheet determines the price investors will have to pay per ownership share in the company. The total purchase price of the percentage of the company the investors paid for will be divided by the total number of shares. Conversely, if you multiply the price per share by the total number of shares issued to the investor, you will get the get a number equal to the total investment.
- Dividends: This term determines the investors right to dividend payouts by the company and who gets priority when dividends are issued. Also, the shares that are issued to the investor determine whether his shares receive dividends or not. However, dividends may not be an ideal way for investors to see a return on their investment, so it’s not the most popular profit-sharing system amongst the company’s owners. There are three primary alternative methods for issuing dividends. The first option is to for the shareholders to be paid dividends in which the cash value of those dividends can be converted into common stock. In other words, the value of the dividend pay out can be converted into equity based on the value of the company’s common stock at the given dividend payout period. The second option is when the owner of the shares receives cumulative dividends. The owner of the stock accumulates a tab (for lack of a better term) of total dividends paid to him/her over the course of his/her ownership of the stock. In the event of the company’s liquidation and/or (IPO) initial public offering (or upon redemption of the stockholder if agreed upon by both parties), the cumulative value of the dividends will be added up. The shareholder will have the right to a cash payout and/or conversion of the dividends to common stock that is equal to this value. The last option is more traditional dividend payout scheme. The shareholder will receive dividends from their stock if/when the company decides to declare dividends. These will be paid to shareholders’ in the form of cash. Of course, the magnitude of value for all of these options (and any mix of these options) is determined by the amount of stock owned by the shareholder.
- Liquidation Preference: Typically, liquidation of the company results when there is a liquidation event — a sale, lease, licensing or transfer of the company’s assets to another entity, or the disposal of the company’s assets (in the case of bankruptcy). Liquidation preferences generally deal with the investor’s exit strategy if the company is bought by another, IPOs, or dissolves. Liquidation preferences determine how the investors will get paid in relation to the magnitude of their ownership and the rights of their shares’ classes. Different classes of stock may confer different rights at a liquidation event. There are three common alternatives that can be laid out in an investors term sheet for such an event. The first, non-participating Preferred Stock, gives the owner of the shares first right to a cash payout equal to the cash value of the original purchase price of the shares plus any dividends. The second alternative is similar to the first except it reserves the shareholders’ right to convert the dollar value to common stock. This can be important to investors if they believe that the company will one day IPO; they may make a higher return on their investment if they hold onto the stock of the company once it becomes publicly traded. The third alternative is similar to the second. The investors are entitled to the original purchase price of the stock as well as all dividends. The dollar value of this can be converted into common stock; however, there is a cap set at specific value. This means investors can cash out once their investment reaches a certain value.