It’s a scenario we’ve seen play out before.
Founders who have bootstrapped their businesses for months, who have pitched for numerous angel investors and networked at countless VC (Venture Capitalist) events, finally manage to get themselves in front of an investor, a term sheet on the table and they proceeded to sign the proverbial deal with the devil.
After months of negative cash flow, they jumped at the highest number on the front page of an 8-page term sheet, unaware of the amount of control negotiated within the finer details of the deal.
Although most term sheets are considered a non-binding agreement, they do formally initiate negotiations, and after they’ve been signed and “executed” guide legal counsel in the preparation of a final agreement.
So when it comes to ceding control of your company in return for investment, we see being forewarned as being forearmed. If you’re entering into negotiations or shopping for specialist lawyers you should have your own understanding of VCs motivations, jargon and the ability to navigate the provisions of a VC term sheets.
This week we’ll be taking you over some of the key economics terms VCs and founders will negotiate within the confines of the term sheet.
We suggest that you always consult a lawyer experienced in structuring VC deals when entering into negotiations.
However, it doesn’t hurt to be just as smart, if not smarter, than your lawyer.
Value & Valuation
Pre and post money valuations are the two ways that VCs will define the price (valuation) of your company.
- A pre-money valuation is what the investor currently values your company at before investment.
- A post-money valuation is the combination of the pre-money valuation plus the intended investment amount.
It’s therefore important for you to clarify whether a VC’s valuation is pre-money or post-money as they both bring different expectations.
During a preliminary discussion about price, an investor says “I’ll invest $ 2 million at a $10 million valuation”. It’s important to be clear on whether this is a pre or post money valuation as this offer can equate to either a 20% or 16.7% stake in the company.
- $2 million will buy 20% of a $10 million post-money valuation ($8 million current + $2 million invested = $10 million post money valuation), whereas it would only buy 16.7% of a pre-money valuation ($10 million current + $2 million invested = $12 million valuation).
It’s important that you, as the founder, be upfront and clear over language being used as there are different expectations for each valuation.
Keep In Mind
The founder, being the eternal optimist, will generally see valuation as being pre-money while the VC usually means post-money.
Preferred & Common Shares
When you incorporated your business, you most probably received common share rights. Common shares represent your ownership in a corporation, its assets and its earning and entitles you to voting rights over the companies direction at shareholder meetings.
However, when VCs begin to invest in your company, they may insist upon purchasing equity in the form of Preferred shares.
Preferred shares are considered a higher form of ownership than common shares and while they generally don’t entitle voting rights they do give investors a higher claim on assets and earnings than common share holders. Preferred shares will also play a role in covering a VCs investments in your company as it gives them liquidation preference over your common shares in the instance of poor financial results.
Preferred shares will play an important role in covering a VCs investments in your company as it gives them liquidation preference and antidilution price protection over your common shares in the instance of poor financial results.
The Liquidation Preference
Ok, this is where it gets complicated, but stick with us because the liquidation preference is one of the most important terms to understand and negotiate within your deal.
In the instance of a merger, acquisition or when a companies assets are put up for sale the liquidation preference determines the amount and order of money returned to which group of company share holders.
This preference provides additional protection to investors by ensuring they recoup their initial investments before other parties.
There are three key details that determine the liquidation preference and founders should be aware of them. As the devil, for this term, is in the details:
(If you find any of these details to be complicated, don’t worry, we’ll be illustrating them all in a working example as well)
- Preferred or Common shares: Prior negotiations over preferred or common shares are important for the liquidation preference. Investors who hold preferred shares (VCs with Series A, B etc. shares) will receive priority pay outs before common share holders (Founders/Management/Employees).
- Multiple Return of Preference (Original Investment): The actual preference entitles the preferred share holders to [x] times the original purchase price of a share. This is a multiple of the original investment that is returned to the preferred share holder before the common share holder receives anything. Usually this multiple remains at 1x, or the amount of money originally invested. However, VCs can push for a preference deal that returns 2x-3x that of the initial investment. If a VC attempts to gouge you with excess preferences such as a 3x – 5x multiple this should be a massive red flag. Excess liquidation preferences can indicate inexperienced investment and have a devastating affect in the sale of a company.
- Types of Liquidation Preference: There are three types of liquidation preference based upon the ‘participation’ status of a share. Shares status as participating or non-participating will order the payout and the amount payed:
- Full-participation – Investors will receive their invested (participated) amount back first, covering their investment, before sharing in the remaining amount based upon their equity in the company. As they are essentially getting paid twice, this version of the preference favours the investor.
- Non-participating – A non-participating investor only receives their ownership amount owed to them. This motivates and favours the founder as it allows them to recoup their original equity in the company.
- Capped participation – A capped investor receives a combination of the two unless its predetermined cap is reached. The cap is a predetermined number, [Y]x the original investment, that when reached means the capped participation investor will simply revert to a non-participating investor and share in the overall sale of the company as a non-participating investor would. As it incorporates aspects of both participating & non-participating preference this approach is generally reached as a compromise between the two parties.
Now for that example of the liquidation preference in action
Investor A invests $5 million, at $1.00 a share, into a company at a $10 million pre-money valuation ($15 million in total).
- They own approximately 33% of the company in non-participating preferred shares while the founder owns approx. 67% in common shares. They have negotiated a 2x liquidation preference and the company is eventually sold for around $12 million dollars.
- The liquidity preference ensures that Investor A’s preferred shares will be paid out first and since they negotiated a 2x multiple on their initial investment Investor A immediately recoups $10 million of the $12 million sales price. The liquidity preference has given the founder 83.3% of the sales price leaving the founder with only 16.7%. Obviously this is less then ideal for the founder but it doesn’t end there.
If Investor A’s shares are considered to be fully participating then the founders share in the sale is diluted to an even greater extent.
- In a full-participation scenario Investor A still takes the $10 million (83.3%), but is also entitled to a equity share of the remaining $2 million (16.7%). Investor A therefore receives 33% of the remaining $2 million, taking their total return from the sale to roughly $10.6 million and leaving the founder only $1.3 million from their 67% equity in a $12 million sale.
Admittedly this is a worse case scenario. But we think it illustrates how powerful the liquidation preference can be within the confines of your deal. However, if a company is sold at a profit the liquidation preference also plays a role in deciding who gets what, in what order.
Again, we feel this is best illustrated with an example
Investor A invests $5 million into a company at a $10 million pre-money evaluation ($15 million in total). They own approximately 33% of the company while the founder owns approx. 67%. The company does well and is eventually acquired for $30 million.
- A 1x, non-participating, preference payout would mean that Investor A gets 33% of the $30 million sale. They receive $10 million and the founder receives the remaining $20 million.
- A 1x, participating, preference payout would mean that Investor A immediately recover his initial investment of $5 million, then divides the remaining amount with the founder according to their equity. In this case, Investor A receives $8.3 million (33% of $25 million) + their initial $5 million for an overall return of $13.3 million, whereas the founder receives 67% of 25 million ($16.7 million).
Now lets run that scenario again with a 2x participating payout.
- Investor A immediately recovers 2x his initial investment of $5 million ($10 million), then divides the remaining $20 million with the founder. Investor A receives 33% of $20 million ($6.6 million) + $l0 million (2x his initial investment) for an overall return of $16.6 million. The founder receives 67% of 20 million (acquisition price minus 2x investment) for a return of $13.4 million.
- Finally, a 1x, participating preference with a 3x cap would not be activated as Investor A’s payout won’t reach $15 million (3 x $ 5million). Therefore their pay out would be the same as the above participating preference payout ($13.3 million).
Now, if we run the same example again, but with a higher acquisition price of $60million we can see the effects reaching the cap has on the participating preference.
- The, 1x, non-participating preference payout would mean Investor A receives 33% of the $60million sale. They receive $20 million, the founder receives $40million.
- A, 1x, participating preference payout would mean that, again, Investor A recovers his initial investment of $5 Million, then divides the remaining $55 million amount with the founder according to their equity. In this case the investor receives $23.3 million ($18.3 million + $5 million). The founder receives $36.7 million.
With a 2x participating payout.
- Investor A immediately recovers 2x his initial investment of $5 million ($10 million), then divides the remaining $50 million with the founder. Investor A receives 33% of $50 million ($16.5 million) + $l0 million (2x initial investment) for an overall return of $26.5 million. The founder receives 67% of 50 million (acquisition price minus the 2x investment) for a return of $33.5 million.
- And finally, the 1x, participating preference with a 3x cap would be activated in this instance as the investor makes a return better then 3x his initial investment of $5 million. In this case Investor A’s payout would be the same as the non-participating preference payout.
As you can see, a participating preference with a 2x feature heavily favours the VC, especially at a lower sales price but has less impact at a higher sales price.
But the question remains, what does this mean for you?
Your next move
If you can demonstrate traction, proof of concept or successfully leverage other VC offers you should push VCs for a non-participating preferred liquidation preference.
However, if your bargaining power is limited or the VC refuses on principle to accept a non-participation preference you will most likely have to settle for a capped participation. This will tip the balance back into your favour if your company can make a meaningful return for your investors.
Worst case scenario, your bargaining power is limited and you’re in desperate need of VC investment so you’re hit with a 4x -6x multiple preference. Accepting a preference such as this will remain a constant issue throughout your companies life cycle. The original liquidation preferences you agree to with your investors set the precedence for any future rounds of financing, so it’s unlikely that your situation will improve, you may need to rethink your options.
Keep in mind
The liquidation preference covers a VCs investment in a likely worst case scenario. However, VCs have to balance between negotiating their best price and protecting their investment while leaving enough incentive to motivate best performance from management. For that reason, be wary of any VCs attempting to gouge your company with excess liquidation preferences (3x, 4x etc. the initial amount) as it can be an indication of inexperienced or short-sighted investment.
That’s all for now…
At the end of the day, behind all the financial dealings and decisions over executive control, VC’s are people and when you’re dealing with people you need to pick your battles.
Make sure you’re not attempting to negotiate against a VCs principles. Sometimes no means no. VCs might flat out disagree with a provision within a liquidation preference because they’ve been burned before, so do yourself a favour and negotiate the terms you can.
Practice your due-diligence and talk to past companies your interested VC has invested in, both successfully and unsuccessfully. Learn from their mistakes, learn what was negotiable, what wasn’t and try to gauge how the VC was as a business partner.
Next week we’ll be tackling the Anti-dilution preferences, another inevitable provision that will appear within a VC term sheet. A provisions you probably won’t be able to eliminate but should certainly focus on minimising the impact it has upon your ownership. We’ll also be going over how to turn a restrictive VC ‘no-shop’ clause into a strategic advantage and how to push along a round of funding.
We’re running this series on term sheets because we believe that founders also need to have an understanding of their current and future rights as well as what they are negotiating within their term sheets. If we could help founders come to the table prepared with:
- A better understanding of the basic concepts, motives and jargon of the VC world
- A strategic approach to negotiating terms
- An understanding of the red flags that signal a faustian pact
Well, we’d be over the moon with that.