Investor Term Sheets
In this note, we will describe some of the features on the term sheets you might encounter. These terms present the preferences afforded to owners of preferred shares. This discussion, while perhaps exhausting given the length, should not be considered exhaustive. Be prepared to be surprised with the terms embedded into any proposed series of shares and associated with any round of funding.
Investing has its privileges
As mentioned in the prior note on the variety of share types, each series of preferred shares can come with its own unique set of characteristics afforded to the holders of that series. While these so-called “preferences” come in a range of flavors, certain flavors are more common than others and will be described in this article. That said, even these more commonplace characteristics of preferred shares can make some heads spin.
Importantly, the specifics of these preferences are negotiable, whether or not they were in fact negotiated. While there may be standard practices (“that’s the way we do things around here”) that lead to the particular terms being present among preferred shares of different companies, there is probably no clear “right” or “wrong” value to the characteristics described below that could be identified other than in retrospect. As a result of negotiations, however, there are preferred share terms that might be “good” or “bad,” or “better” or “worse” for either the startup, the investors, or both parties.
Importantly, not all preferred shares are created equal. Any series may be designated as “senior” to other series that have been issued. As a result, the terms of any more senior series must be fully met before the terms of less senior series can be met.
Common among preferred shares is the promise of a dividend, whether presented as a fixed amount or as a rate of interest. Furthermore, this dividend amount/rate is often not only fixed, but also cumulative. If a firm chooses to or is unable to pay a dividend promised in any period, those unpaid dividends accrue and must be eventually paid in full. This fixed dividend structure offers preferred shareholders certain benefits otherwise ascribed only to bondholders.
Preferred shares can almost always be converted to common shares. The ratio at which this conversion can occur could be just about any ratio that can be imagined and then successfully negotiated, but is often just 1 preferred share to 1 common share. The conversion of preferred shares to common shares could occur for a number of reasons. The most likely reason, however, is an acquisition. The acquiring firm purchases—whether with cash or their own stock—the common shares of the startup. As a result, preferred shareholders that would like to participate in this sale convert their preferred shares to common shares.
LIQUIDATION / PAR VALUE
Preferred shares may carry the protection of a liquidation preference, pegged at some par value or, more simply, the initial price paid for the shares. Liquidation preferences simply describe the value of the shares in the case of a liquidity event—whether that event is a sale, a liquidation of assets, or otherwise.
In the wild, there are two predominant forms of liquidation preference: non-participating and participating. The following section describes these two forms, while you can find examples of capitalization tables and payouts—under different liquidation scenarios—linked here.
In the binary world of a non-participating liquidation preference, preferred shareholders are owed either the greater of the liquidation of their preferred shares or the value of their common shares upon conversion. The language of a non-participating liquidation preference might sound something like the following:
First pay ONE times the Original Purchase Price plus accrued dividends on each share of Series X Preferred (or, if greater, the amount that the Series X Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.
In such a situation, the question upon liquidity is simply: would the preferred shareholder’s shares, if converted to common shares (or simply their proportion of the total share pool) be worth greater than or less than the value of their liquidation preference?
An investors holds $1,000,000 in preferred shares, which if converted to common shares, would represent 20% of a company’s total outstanding common shares.
Scenario A) The company is to be acquired for $10,000,000.
20% of $10,000,000 is $2,000,000, which is greater than $1,000,000 (the liquidation preference, or par value of preferred shares). The investor would be owed the conversion of their shares to common shares, and the value of these shares.
Scenario B) The company is to be acquired for $4,000,000.
20% of $4,000,000 is $800,000, this is less than the $1,000,000 value of the liquidation preference. The investor would be owed their liquidation preference.
To compensate for the perceived limitation that is a fixed liquidation value (preference or perquisite is in the eye of the beholder), certain investors may request a liquidation preference that is greater in value then their initial investment. This feature is known as the multiple liquidation preference, and is termed (more often than not) as a multiple of their share price.
Note, liquidation preferences and multiple liquidation preferences, in particular, can set in motion an awkward situation around a liquidity event for the firm.
A firm acquired for $15,000,000 that has $10,000,000 invested through preferred shares with a $10,000,000 value at par (the liquidation preference) and 1.5x multiple on that liquidity preference returns $15,000,000 to preferred shareholders and $0 (zero) dollars to common shareholders.
In the example above, the founder(s) and employee(s) get nothing more than a press release and a new job from the acquisition even though they provided the investors with a 50% return on their money.
Participation describes the ability of a preferred shareholder to enjoy the benefits of both their liquidation preference and the value of their shares if converted to common shares. This participation tends to be structured in a particular manner. The language of a participating liquidation preference might sound something like:
First pay ONE times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.
Essentially, upon a liquidity event (such as an acquisition), the preferred shareholder(s) first peel from the acquisition price the value of their liquidation preference (i.e., the price paid for their shares, or some multiple of this price). Then, these shareholders “participate” in the remaining dollars according to their proportion of the share pool as if or by converting their shares to common shares.
A startup is acquired for $25,000,000. Preferred shareholders, upon conversion, would own 50% of the share pool. These preferred shareholders not only acquired their shares for $10,000,000 and, collectively, hold a liquidation preference at that amount, but also hold a right to participation.
First, these preferred shareholders would get their $10,000,000 due from the liquidation preference, leaving $15,000,000 left on the table.
Second, thanks to the participation preference, the remaining amount ($15,000,000) would be distributed according to each shareholder’s proportion of the common share pool, of which preferred shareholders (converted to common) own 50%.
As a result of their participation preference combined with their liquidation preference, preferred shareholders would receive $17,500,000 of the purchase price, which in this case is actually 70% of the purchase price.
Furthermore, while common shareholders held 50% of the total share pool, their portion of the acquisition value would be reduced to 30%, which in this case is $7,500,000.
$25,000,000 - $10,000,000 => $15,000,000 * 0.5 => $7,500,000
Depending upon your perspective, participation is either (a) a perquisite along the lines of, “Have your cake and have some of my cake, too!” or (b) an appropriate level of compensation given the risk being taken by the investor.
For a Google Sheet whereby you can see the difference in Payouts from an acquisition in the context of a Participating Preferred term versus a Non-Participating term, follow this link.
CALL / REDEMPTION
Preferred shares might be callable by the issuer (i.e., the startup firm) or redeemable by the buyer (i.e., the investor). A preferred share is a callable when the clause exists for the firm to “call” preferred shares back, buying these shares at par value (or some other prescribed value) at the option of the firm. A preferred share is redeemable (or there is a redemption preference) when the clause exists for the buyer to “redeem” these shares, selling their shares back to the firm at par value (or some other prescribed value) at the option of the buyer/holder of those shares.
In startup land, it is likely you will see a redemption preference included in a term sheet. This redemption however might time out, or not be triggered until a certain amount of time has passed.
It is not altogether common, however, to produce callable preferred shares, or preferreds whose callable provision could trump the conversion preference. Otherwise, the firm could limit preferred shareholders to only the upside of their liquidation preference in an acquisition by “calling” the preferred shares.
Anti-dilution clauses provide a protection to a preferred shareholder should a subsequent funding round occur at lower valuation, or subsequent sales of the same series of shares be at a lower price. Anti-dilution permits the shareholder a lower effective share price by raising the conversion rate previously associated with their shares—meaning the shareholder would receive a greater number of common shares, upon conversion, for their initial investment. The clauses will employ weighted-average or “rachet” terms to describe the method through which a new conversion rate is established.
I will not go into more detail on the nature of anti-dilution clauses. Simply put, any clause that mentions an aunt, aunty, or anti-anything needs to be read very, very carefully.
While uncommon, but not altogether impossible, one of the preferences that can be afforded to preferred shares is the right to convert or “upgrade” those shares for shares (predominantly other preferred shares) in subsequent rounds of funding. As a result, holders of shares with upgrade privileges can convert some or all of these shares to some newly issued series and even sell these upgraded shares as part of the funding round during which the new series is being issued.
The Founders Fund has become known for adding this upgradable conversion to a series of shares—dubbed series FF—issued and sold/distributed to select individuals, usually the founders of the firm.
THIS NOTE IS STILL UNDER CONSTRUCTION
For further reading:
Model Documents for Early Stage Investments. The British Venture Capital Association (October 2007)
Brad Feld (2005). Term sheet series wrap up. Feld Thoughts.