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Understanding The Investment Term Sheet

  1. Understanding The Investment Term Sheet Mohammad Albattikhi @MAlbattikhi
  2. A non binding agreement between owners of a company and investors for setting the terms under which an investment will be made. What is a Term Sheet?
  3. Economics The return on the investment in the liquidation event, such as selling the company or an initial public offering (IPO) Control What allows the investors to exercise control over the business or to veto certain decisions The 2 Things That Matter
  4. High Demand = High Price (Valuation) Current investor will increase the valuation to limit the dilution from new investors. Note: If existing investors want to re-invest, they will argue for a flat round (equal to previous round) or a down round (Less than previous round) Investment Economics 101
  5. Pre money Valuation Valuation of company before receiving the investment Post Money Valuation Valuation of the company after receiving the investment (Pre money valuation + Investment = Post money valuation) Investing $5M at a Pre-Money $20M valuation = 20% Investing $5M at a Post-Money $20M valuation = 25% Valuation
  6. • Stage of the Company • Competition with other funding sources • Experience of Founders and Team • The VC stage of financing • Numbers: Sales, Revenue, Projections, Cash Burn; etc. Valuation Factors
  7. Capitalization Table The Cap Table is the ledger that shows who owns the company. When you sell the company, it determines who gets paid what. It also shows who can vote and how much power they have in the company
  8. Common Stock • Exercise control by electing a board of directors • In the event of liquidation, common shareholders have the rights to the assets after preferred shareholders and debt holders. Preferred Stock • Have higher priority to claim assets and earnings than common shareholders • Don’t usually have voting rights Stocks Type
  9. • Seed Financing • Convertible Notes • “Series Seed” or “Pre-Series A” • Series A • Series B • ….. • Series Z Note: Sometimes, you’ll find Pre-Seed or Pre-Series A. There’s also bridge rounds Financing Stages
  10. Convertible Note A short term debt that converts into equity at an agreed on maturity date or in conjunction with future financing rounds. The most important things about a convertible note agreement are: Discount Rate Since the convertible note holders bore more risk investing earlier in the company, they get a discount on the share price, which is usually 10% - 20%. Valuation Cap The valuation cap provides the convertible note holders with a maximum valuation protection in case the company’s valuation takes off
  11. Preference In the event of liquidation, the Preferred Shareholders can be entitled to receive 1x, 2x, 3x, or even 10x per share more than the common shareholders.This is not a common practice these days. Participation • Full Participation: Pay back the investor, then split the profits • No Participation: split profits based on ownership percentage • Capped Participation: Investor gets the highest option between the agreed cap (e.g. 3x the investment), or full participation. Liquidity Event: a sale of the company of the majority of the company’s assets Notes: Always give Investors No Participation Liquidation Preference
  12. There are two approaches: Stacked Preference Series C gets its preference first, then series B, then A —In case of low liquidation, the last series investors might get paid 100% of the liquidation, and everyone else will get nothing Pari Passu (Blended Preferences) All series are equivalent in status. So series A, B and C are proratably until the preferences are returned Liquidation Preference (More than one Series)
  13. • Example Scenario: Liquidation at $15 Million • Stacked: Series B will get $15M, Series A will get nothing • Pari Passu: Series A gets 20%, and B gets 80%. The entrepreneur gets nothing since the preference is $25M Liquidation Preference (More than one Series) Series Investment Pre-Money Valuation Post-Money Valuation A $5M $10M $15M B $20M $30M $50M
  14. Gives the investor the right to invest purchase “x” amount of shares at a predefined prices for a “y” period of years Example: a 10-year warrant for 100,000 shares at a $1 per share gives the investor the option to buy 100,000 at anytime over the next decade for $1 per share. Warrants create a lot of complexity. Avoid them, even if you end up lowering the pre-money valuation. Warrants
  15. Pro rata gives the investor the option to invest in the company in future rounds at the same valuation Note: Pro rata is a latin word that means ‘in proportion’ Pro rata rights
  16. Investor must keep investing in future financing rounds in to avoid having their preferred stock converted into common stock. If an investor invests but not to the full extent of his/her pro rata share, then a percentage of his/her share convert from Preferred to Common Pay-to-Play
  17. Used to protect investors in case of down rounds (i.e. selling shares at a lower price than previous round) • Full Ratchet Antidilution: Means that if the company issued shares a lower price per share than previous round, the earlier round is effectively reduced to match price of current round. Note that you can agree on half ratchet, 2/3 ratchet, etc. • Weighted Average Anitdilution: The number of shares issued in the current investment round is used in the re-pricing of the previous round. • New Conversion Price = Old Conversion Price x ((Common Stock Outstanding + Common Stock Purchasable) / (Common Stock Outstanding + Common Stock Actually Purchased Anti-dilution
  18. Gives the investors to right to force all shareholders to sell the company, regardless of how they feel about the sale Drag-Along
  19. Equity (or stock option) reserved to compensate and motivate the employees working at the company. 10% employee pool is a typical practice Investors might ask for increasing the pool from 10% to 20%. This will reduce the pre money valuation by 10% (e.g. from $20M to $18M) Note: having a 10% - 20% employee pool is acceptable. If the investor insists on increasing the number to 20% try to negotiate it to 15%. Note: By increasing the option pool, investors will reduce their chance of getting diluted Employee Pool (Option Pool)
  20. A mechanism that ensures the equity is earned over time. This can be used to make sure founders will not leave the company, or to motivate employees to join and stay with the company. For Example, giving an employee 3% equity vested over 3 years, means that the employee will get 1% equity after completing each year in the company. Vesting