As a startup founder, you don’t only have to be an inspirational visionary, you also have to be able to take on multiple roles in your company. One role in particular, has stumped many founders – that of the legal advisor. Founders often find themselves overwhelmed with technical legal jargon when discussing investment terms with VCs.
While it would be best to seek legal advice from licensed lawyers, a founder should still ensure that the terms and conditions laid out in VC term sheets are fair and will not leave them in a sticky legal battle should investor relations go south. Here’s a brief rundown on what to lookout for in VC term sheets for budding entrepreneurs looking to seal a deal with a VC.
- Pre-money and Post-money
When you begin negotiations, VCs will dive straight into your company’s operations, finances and history, applying varying forms of formulae to estimate the potential value of your company. Through this rigorous exercise of due diligence, they will then be able to finalise your company’s pre-money valuation.
Your pre-money valuation basically denotes the value of your company before the VC’s investment. If the latest injection of funds is factored into the valuation, it is then described as a post-money valuation. Whether the latest investment is based on pre-money or post-money, it can make a lot of difference to the amount of shares you will be giving to your newest financier.
Let’s say your company is valued at $4 million, and your investor decides to pump in $1 million worth of funds. Here’s an example what it means if your valuation is based on pre-money VS post money:
- Option Pools
As a startup, both you and your investor are looking to attract promising new talent who are skilled, and are also invested in the success of your company. Salaries won’t be as attractive since you’re trying to keep your burn rate at a minimum. So what does a founder has to offer? Company shares. Keep a lookout for mentions of option pools in your term sheet as this will affect the overall value of your shares. VCs may wish to set aside shares that will be potential future employees. What’s important is to figure out the percentage of shares that will be set aside, and if it is in line with your hiring plan. Based on the previous example, here’s an illustration of how an option pool of 20% shares can affect the value of your own shares:
As illustrated, having an option pool of 20% can reduce your share amount significantly if not kept in check. Have a good idea of the positions you plan to fill in the next couple of years and set aside an appropriate number of shares for your new hires.
- Type of shares
Being an early investor, VCs tend to request for preferred convertible stock. To understand what this means is to understand the nuances that come with preferred stock.
Preferred stock gives the investor a claim over company assets which ultimately gives them first dibs on dividends, proceeds from an exit or money from a liquidation event. Preferred stockholders receive pay-outs earlier, and in higher amounts than common stockholders.
Convertible stock allows the stockholder to convert their shares from preferred to common stock. Based on what was mentioned earlier, why would an investor wish to exercise this option? If your company experiences exponential growth and share prices shoot through the roof, preferred stock will NOT rise as quickly as common stock. The option to convert to common stock gives the investor a win-win situation.
- Anti-dilution policies
These provisions will definitely come up in your term sheet as a means to protect the VC’s investment. These policies are put in place to ensure that the shares owned by the investor will not be ‘diluted’ in the event of a reduction in share prices. For example, your company decides to IPO at $10 per share, while your investors initially paid $12 for each. Anti-dilution policies will ensure that investors will be able to retain the original value of their shares despite the new valuation. There are two mechanisms in which anti-dilution policies can be effected:
- Full Ratchet
This mechanism would mean that your VC will be able to completely retain the original value of their investment. For instance, if your company originally sold 20% worth of shares to your investor at $1,000,000, and you now need to sell shares at half the price, your investor would now hold 40% of your company shares based on the new value.
- Weighted Average
This mechanism takes into account the number of shares being sold at the new price. If only a few shares are being sold, the investor’s share amount will not increase so dramatically. The more shares you sell, the more shares your investor will own.
There is a whole dictionary of terms that may leave founders dumbfounded, and we’ve only scratched the surface. Hopefully you’ll now be able to pick out key terms and even out the playing field when negotiating with investors on your term sheets.
Choosing the right term sheet and going with the VC of your choice will greatly affect the progress of your company. Here are a few things to look out for when deciding which term sheet offer to pick