Decoding the Term Sheet - Chapter II
In most of the cases while raising investment, it is expected from the founders that they must also ensure to set aside sufficient stock options to compensate or incentivise their employees or other stakeholders.
The second most important life-event for a startup, as we discussed in our last article is to raise capital to develop a company. This leads us to the most challenging part of funding and valuation: The Term Sheet. In our example, as Aditya holds the term sheet he is surprised to note that there are quite a few terms he is unaware of. Though Moneybags is poised to received funds, he is not sure if he should go ahead and accept the Term Sheet. Will he understand the details hidden behind and the jargon and to protect the interest of all the stakeholders including his and his employees? In this article, we will write about these terms for the benefit of Aditya and our readers.
This piece is all about shares. Though we briefly touched upon the subject of common stock and preferred stock, in the last article, we will go over it in greater detail here:
Stock, shares or equity are a representation of the ownership of a company. Holding a certain percentage of stock gives a stockholder proportionate share in the profits. Based on the percentage of holding it may also give a stockholder the right to vote on corporate matters and on appointment of Board of Directors. Profit distributed among the stockholders mostly come in the form of Dividend. Dividend may be paid yearly or quarterly, but it is neither fixed nor mandatorily and startups may decide to reinvest the profit in the company instead of distributing as Dividend.
In most of the cases while raising investment, it is expected from the founders that they must also ensure to set aside sufficient stock options to compensate or incentivise their employees or other stakeholders. This is known as the Employee option pool or the Employee Stock Option Pool (ESOP). An ESOP, in case of startups, mostly used for allocation of some equity to early employees to compensate their initial contribution (and less salaries) in hope of giving long term returns. ESOP is typically used to benefit employees, consultants, directors, advisors etc.
The size of an Option Pool is keenly contested in valuation negotiations and varies significantly across industries. Globally it has been found to hover between 10-20% of the post money valuation but depends on a Firm’s hiring plan and hiring needs. The option pool is usually carved out by diluting the founders’ shares as they do not have a founding team or a complete team in place in the preliminary stages. Also, after investing a hefty sum of money, Investors/ VCs do not prefer dilution of their capital position/ share value immediately post valuation.
Preferred stockholders have a greater right over common shareholder with respect to the dividend pay-outs, liquidation preferences and other reserve matters. In some cases, Preferred stockholder may not have voting rights but this is not uncommon. In a liquidation event, after bond holders and creditors have been paid, the remaining assets will first be distributed to the preferred stockholders and then the common stockholders. This class of stock is superior to common stock in the sense that their investment is protected and they have higher returns. In case of exit as well, Preferred stockholder may carry preferences with hurdle rate that will result in returning X times of the investment amount to the holders of this class and then equally distributing the leftover proceeds among all the stockholders including Preferred stockholders. Start-up founders should be very informed and aware of what term they are agreeing with their Preferred shareholders as the meaning of Preferences can be totally different in every case and it can be much more than classical definitions of Preferred stocks.
Warrants are like stock options that can be attached with common or preferred stock. They give the holder the right but not the obligation to purchase a certain number of stock at a predefined price, called the exercise price or strike price before expiration. It is widely believed that it leads to a lower valuation of his company. If a term sheet states that there will be an 8-year warrant of 100,000 shares of Series A stock at Re. 1 per share, it gives the investor the option to buy 100,000 shares at Re. 1 anytime in the next 8 years irrespective of the price prevailing at that moment. If the stock price has soared to Rs. 5 in these 8 years, the investor earns a heavy profit of Rs 4,00,000 on his capital. Though Warrants act like ESOP, they can be allotted to someone who is not working directly with the company like employees or consultants etc. It is not very common to see Warrants on term sheets.
Bridge loan is a short-term loan, for a period varying anywhere between 2 weeks to 3 years and required for immediate cash flow to meet short term obligations. Called bridging loan or caveat loan in the United Kingdom, this type of financing is done when there is a larger or long-term financing around the corner.
Bridge loan financing often involves warrants and is done when an investor is planning to do a financing but is waiting for participation by additional investors so that they can have a big round.
Recently one of Spark10’s startups were waiting for a distribution license from a private bank in India, and an angel investor was ready to invest the money as soon as license is granted – but for getting the license startup had to give some money as deposit. So, the investor has extended a small bridge loan to help the startup finish the licensing process and then invested in the company as promised.
Before we explain what liquidation preference is, it is important to understand the meaning of a liquidation event. Liquidation event is a typical exit strategy of a company which converts the ownership equity held by the founders and investors into cash and could include events like sale, acquisition, initial public offering, change of control or consolidation of the company. Liquidation preference is also applied in situation like sale of the share capital of the company or of all or substantially all the assets or merger of the company. It is frequently used in term sheets to specify which investor gets paid first and how much in case of a liquidation event. It is made up of two components: actual preference and participation. Participation can be full, capped or nil.
In case of a liquidation event, the preferred shareholders of a company would receive proceeds from the sale in a certain multiple of the original investment first and then the common shareholders based on the terms of the liquidity preference. Usually the actual preference is 1X but it may differ based on prevailing market conditions.
See sample language from Aditya’s term sheet:
On a sale of the share capital of the Company or of all or substantially all the assets of the Company or merger of the Company, Shareholders shall first receive back an amount equal to the Issue Price (the “Preference Amount”) in priority to and before any distribution of any surplus. To the extent, the Company has any assets remaining after distribution of the Preference Amount, these will be distributed to all shareholders’ pro rata. If the Company does not have such funds available to pay to the Shareholders the Preference Amount, the Company shall distribute the funds available to it pro rata amongst the Shareholders in proportion to their shareholdings in the capital of the Company.
Full Participation: Also, called the double dip preferred, the preferred shareholders whose stock is fully participating will first receive the entire amount they had invested plus any accrued dividends and then also receive equal share in the remaining proceeds along with the common stock holders. This is most favourable to investors.
Capped or Partial Participation: It is an intermediate approach in which the stock will share in the liquidation proceeds till an aggregate return is reached. Once the threshold is reached, they no longer have a share in the remaining proceeds along with the common stockholders. Capped participation usually comes for 2 to 5 times the investment amount.
No participation: This means the preferred stockholders of the company would receive the entire amount invested if the company is sold prior to the distribution of the proceeds to common stock holders. They also have an option to convert their stock to common stock and be treated as common stockholders in terms of sharing of proceeds. This is favoured by most founders, but a rare term to come from a sophisticated investor.
When a startup raises multiple rounds of investments and the latest round comes with higher preferences than earlier rounds, investors will be paid only after satisfying the preferences of the latest round.
For example, if MoneyBags has raised Rs. 5,00,000 in series A and Rs. 15,00,000 in series B round and issued Liquidation preferences to both the investors then there are two possibilities –
1- Stacked liquidations preferences – where series B investors preferences will be satisfied before series A investors’ and then common shareholders including Aditya will be getting money. So, if exit takes place on anything less than Rs. 15,00,000 then full money will be given to series B investor and everyone else gets nothing. But if exit took place on say Rs. 20,00,000 then first Rs. 15,00,000 will be given to series B investor and then Rs. 5,00,000 will be given to series A investor. Now there is no money left so others will not get anything. If exit took place on more than Rs. 20,00,000, say Rs. 25,00,000 then first Rs. 15,00,000 will be given to series B investor, then Rs. 5,00,000 will be given to series A investor and rest of the money will be either distributed to all the stockholders including series B and A investors (full participation) or to other stockholder (partial participation with 1X return).
2- Blended liquidation preferences – where series B and series A investors will share the same preference rights over common shareholder, proceeds will be distributed to preference stockholders on pro-rata basis first and then will be given to others on the bases of participations. Hence if exit took place of Rs. 12,00,000 then distribution among series B and A would be Rs. 9,00,000 and Rs. 3,00,000 respectively and others will not get anything.
VESTING OF SHARES
To keep both founders’ and investors’ interests aligned, vesting has become a must. Vesting of shares means that founders, advisors or consultants must earn their shares over time by contributing to value creation for the company. If there is a situation where any of the founders have decided to discontinue with the company then they should only own the part of the company that they have contributed to and not the whole equity that was discussed and allotted to the founders under the assumption that they will stick to the company through its journey.
Vesting means that instead of getting their shares immediately, founders get it regularly over a period. For example, if Aditya had a co-founder Abhishek, and both have 35% stake each and Angel investors own 30% of the equity shares. They have a vesting period of 5 years with a 1 year cliff. A 1 year cliff means that if either of the founders quit the company in the 1st year itself, he gets nothing. If he completes a year then every year till they reach to fifth year, they will own 20% of their allocated holding that means from second year onwards both the co-founders will own 7% every year until they reach to 35% and in the event, that he quits before such time, the company repurchases his equity on the base price.
In a scenario where the company gets acquired before the vesting period is over, upon change of control, all the unvested shares become vested. This type of accelerated vesting is called Single trigger acceleration. In contrast, Double trigger acceleration requires two conditions to be met before full vesting is accelerated: change of control and firing of the founder within a specified time frame. While single trigger is not common, the vesting conditions depend completely on the negotiations between founders and their investors.
Aditya found these explanations helpful and is now in negotiations with his investors over the Term Sheet. While we have made the best effort to simplify key terms of the Term Sheet, this is by no means an exhaustive list. We will continue to visit more such terms in our next article.
Atal Malviya is the Chief Executive Officer of Spark10.com – India’s first European Accelerator. Atal is a successful entrepreneur and an angel investor based out of London. He has founded and exited VC funded technology startups and invested in handful of technology startups in Europe and India. He writes and speaks about Tech Startups, Startups investment, Accelerators and Incubators, Tech innovations and Big data analytics.
She is Content Manager at Spark10.com. Swati has joined Spark10 Blore last month from Goldman Sachs.
PS: This article is for information purposes only and meant for tech startup founders or aspiring entrepreneurs. Examples used are fictitious. Please take professional advice when you make your funding decisions and Spark10 will not be responsible for any decision that you take or conclusion you draw from, based on this article.
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