Understanding the Terms: a Primer

What is a term sheet?

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When deciding to finance a start-up through crowdfunding, it is important to know and understand the terms of the transaction. Stocks come with a series of rights and provisions that are usually covered by a mutually agreed upon “term sheet.”

Because we, at truCrowd, are addressing unaccredited investors we want to make things as easy as possible.  In this blog post, we try to explain in plain English the main definitions of the contents of a “Term Sheet.”

Which are the terms included in the term sheet?

Valuation – represents the company’s value in dollars. It can be pre-money valuation, meaning company’s value before any new investments are made or post-money valuation, which represents the company’s value after the investment. Post-money valuation is the sum of total new investment (often referred as $Y) and the pre-money valuation (often referred as $X).

Type of Security – Usually companies issue stock in exchange for the invested money. The stock can be common or it can carry a series of rights, preferences, and privileges for the investor, such as the right to receive the proceeds of an exit before holders of common stock.

Dividends are the money investors may receive at the end of a financial year, proportionate to their investment. The term sheet usually has the mission to state clearly the conditions in which the dividend will be paid (or not).

Liquidation Preference – Stock can carry a special liquidation preference, usually from 1x to 3x, which means you, the investor, will be able to receive from “the same amount” (1x) to “triple the amount” (3x) the original investment in the event the company is acquired, merged, or sold. The generally accepted and reasonable preference is 1x, but, in case of riskier business, it can be well higher.

Participation represents a benefit from the company’s performance. It can be conditioned by a certain positive event (participation with a cap) or happening no matter what (fully participating). Frequently, “non-participating” is preferred, which means investors do not share the distribution of remaining proceeds following the receipt of their preference.

Option pool – A start up usually prefers to reserve a share of stock for its own employees and other partners, as an instrument of stimulating them and rewarding them for the company’s eventual success. This is called option pool and it typically varies from 10 to 20 percent of the total amount of stock, a percentage determined either pre- or post-money.

Conversion – Preferred stock can be transformed into common stock and the specific process is called conversion. The price paid per share in case of such a transformation is being referred to as conversion price.

Anti-Dilution –  anti-dilution rights guarantee the investor that in the event the number of shares changes without corresponding impacting economics, his number of shares  automatically will be modified accordingly, so his percentage of the total will remain unchanged. Investors also try to optimize downside scenarios, when new shares are issued for less than the conversion price, which often implies protecting their ownership at the expense of the company and other investors. These provisions are known as “priced based anti-dilution” and they include full-ratchet anti-dilution – rarely seen in contracts and is very disadvantageous for the company, and weighted average anti-dilution –  the moderated version for both investors and the company, but possibly not great for the new investors.

Pay to play covers the difficult times to come for the company, by asking for financial support from the investors when things will turn out harsh. This support may be represented by conversion to common stock and renouncing at any preferred rights, cancelling the anti-dilution protection, or giving up certain special control rights. Pay to play can be invoked only in difficult times for the company, to save it from unwanted scenarios, so it can be seen as the best overall alternative in a severe situation.

Warrants represent rights given to certain investors to buy more stock at a certain price in a determined timeframe. It is often seen as a company’s way to reward investors who became engaged in the investment process at a very early or risky stage. The downside is that when warrants are exercised, it is dilutive for subsequent shareholders.

Costs of Counsel – Investors may ask for reimbursement of a certain amount of the legal fees involved.

Participation Rights – Also called right of first refusal (ROFR), participation rights represent the company’s obligation to sell stock in future financing rounds to an existing investor.  It is usually equal to the percent of shares the investor already owns – if he has 2%, he may buy 2% in the next round, as well.

Co-sale right states that when the founder or some other key investor decides to sell some part of his stake, the investor has the right to sell the same percentage of stock, to the same buyer.

Registration rights represent the investor’s possibility to claim that the issuing company registers the shares with the SEC, making the stock available for sale to the public, if and when he wants to sell his ownership.

Board Representation – Because, optimally, a board functions with 3 to 7 directors and they have to represent founders and executives, investors, and even independent members, receiving board direct representation is quite rare. There is also the possibility of claiming a board observer position, but this situation, as well, presents many disadvantages for the ability of the board to function well, starting from restraining the board’s typical discussions and activities to even interrupting them.

Voting Rights – It is recommended investors be granted the right to block initiatives that might influence them disproportionately or in an unfair manner, in case major actions are to be taken, through voting rights.

Information Rights – Investors who are not granted board seats may ask for and receive information rights. At this point, as long as the disclosed information is not highly confidential, there is no risk involved to the company.

Major Holders – Most rights usually are confined to major stakeholders, in order to generate less trouble for the company. Major holders are usually evident by the percentage of shares they own, versus the other investors.

Drag Along – It represents the right of major shareholders to “drag along” with them the smaller investors in a sale decision of the company, eliminating the possibility that smaller shareholders block the transaction until they get higher payments.  Even if it is generally seen as a good thing for the company,  there are situations in which a substantial minority shareholder shares the same liquidity vision as the company itself and the dragging along right should be analyzed further.

Conclusion

A term sheet may be a complex mix of the previously mentioned terms, or it can exclude some of them because they may represent situations difficult to predict or not applicable to a certain business. As a conclusion for a future investor, it is important to know that:

  • Term sheets have to be clear and easy to understand;
  • The investor is entitled and even recommended to negotiate terms, so information is critical;
  • Term sheets represent a long series of rights for investors and concessions from the entrepreneurs, so flexibility from both parties will result in defending company’s overall best interests.

 

Posted in Equity Crowdfunding, Investors

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