10. The Term Sheet (Brad Feld)

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Brad Feld joins Nick on The Full Ratchet to discuss the Term Sheet including:

Economic Terms:

  1. Valuationbrad_feld_term_sheet
  2. Liquidation preference:  preference and participation
  3. Pay-to-play
  4. Vesting
  5. Employee pool and/or the option pool
  6. Anti-dilution

Control Terms:

  1. Board of Directors & Board Observers
  2. Protective Provisions
  3. Drag-Along Agreement
  4. Conversion

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The Term Sheet

 

Key Takeaways:

1- Preference and Participation

First we talked about preference… ie. Preferred shares vs. common shares. While preferred shares are still equity and are not senior to debt, they are senior to common stock. So, in the event that shareholders are paid out, those with preferred shares will receive their capital first. The standard in the industry is a 1x liquidation preference… which means that in the event of liquidation, the preferred shareholders can choose their liquidation multiple, often 1x the original purchase price, in lieu of their equity percentage and prior to any other payouts.

So Brad, walked us through the following example… and this is a simple example where we do not have to consider participation, b/c there was no participation.

Preferred, No Participation… three different exit values:

1x Liquidation Preference, no participation:
$10M has been raised over the life of the business
Through fundraising, 50% of the total equity is distributed to investors in the form of preferred stock, for that $10M
Upon a sale of the business, the investors have a choice. They can either take 1x their original investment amount of $10M (ie. the Original Purchase Price), or they can take 50%, their equity position, of the liquidation value (ie. The Current Price)

So….
if company sells for $14M… the investors will receive $10M (b/c they had the choice between $10M or $7M)
In this example, the remaining common stock holders, employees and founders, end up with $4M

For this example the break-even liquidation amount is $20M, where the investor gets the same cash return of $10M whether they choose the original purchase price value or the 50% of the sale price.

If we assume a much higher exit price is $100M, then they will choose their 50% equity distribution and receive $50M.

  Scenario 1 Scenario 2 Scenario 3
Preferred or Common: Preferred Preferred Preferred
Preference multiple: 1x 1x 1x
Participation: None None None
$M Raised (Series A): 10 10 10
Series A post-money valuation: 20 20 20
Investor Equity % (Series A): 50% 50% 50%
Sale Price: 14 20 100
$M paid out to preferred shareholders: 10 10 50
$M paid out to common shareholders: 4 10 50

 

Preferred, Yes Participation… three different exit values:

Now let’s look at a Participating scenario.
Remember with Participation you get your investment dollars back first, then you get 50% of what’s left.

So in the $14M sale price example, the investors will get their money back (ie. $10M) plus they get 50% of what remains (ie. $4M), for a total cash return to investors of $12M. Employees and founders and up with $2M.

In the $20M sale price example, investors get their $10M + 50% of the remaining 10, for a total of $15M. Common stockholders in this scenario will get $5M.

And with a $100M sale price, investors get their $10M, + 50% * the remaining 90M. So $45 + 10 = $55M. The common shareholders get $45M.

  Scenario 1 Scenario 2 Scenario 3
Preferred or Common: Preferred Preferred Preferred
Preference multiple: 1x 1x 1x
Participation: Yes Yes Yes
$M Raised (Series A): 10 10 10
Series A post-money valuation: 20 20 20
Investor Equity % (Series A): 50% 50% 50%
Sale Price: 14 20 100
$M paid out to preferred shareholders: 12 15 55
$M paid out to common shareholders: 2 5 45

 

Participation Cap (if the cap multiple is exceeded, then participation does not apply):

The last example I wanted to review is with Capped Participation. Recall that when the simple, non-participating, return to investors exceeds the cap, then participation does not apply. When the simple, non-participating, return is less than the cap, then participation does apply.

So, in the first scenario, at a sale price of $14M, the simple, non-participating return to investors was $10M. So if we assume a cap of 3x, that is less than 3x their original investment of $10M, so participation does apply and the payout to investors is the $12M from the participation example.

In scenario two, at a sale price of $20M, again the simple return of $10M is less than 3x of the original investment of $10M, so participation applies and the payout to investors is the $15M from the participation example.

And finally, at a sale price of $100M, the simple return of $50M does excced 3x the original investment of $10M, so participation does not apply, and the investors receive the payout of $50M from the non-participating example.

  Scenario 1 Scenario 2 Scenario 3
Cap Amount: 3x 3x 3x
Cap Exceeded? No No Yes
$M paid out to preferred shareholders: 12 15 50
$M paid out to common shareholders: 2 5 50

 

And these are the straightforward examples… remember that Brad mentioned stacked participation as well in scenarios where their are multiple rounds of investment with stacked preferences.

2- Vesting

Recall that Brad discussed founder vesting and how that is seen as investor friendly, but often it can be more important for dynamics between co-founders than it is between the investor and the founder. He has seen multiple situations where a founder leaves and retains his/her equity position… then the remaining founders have to continue working to build the company and receive no greater % of the business than the founder that departed. This can be a very difficult situation and can be very de-motivating for entrepreneurs.

3- Conversion

As Brad outlayed, there may be situations where a strategic acquirer offers $100/share for common stock and $1/share for preferred. This is one of the few cases where it’s more advantageous or the investors to convert to common for a better financial payout… and you will find that conversion is nearly always included in a term sheet, just in case, particularly with a preference.

 

Tip of the Week:  Great Risk Merits Great Reward

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