Defining Terms Understanding
You’ve impressed a number of venture capital firms, and now it’s
time to sit down face to face with these potential partners, find
out what they can do for you, and discuss terms. The terms of an
investment agreement are spelled out on what is called the term
sheet. To help prepare you for this discussion, here are
some brief definitions of terminology found in term sheets.
Negotiating the terms of the agreement is part of establishing
a close working relationship with your venture partner. When working
with you, Woodside Fund seeks to gain an in-depth understanding
of your goals, concerns and expectations so that the agreement matches
both organizations’ objectives for growth and success. Our "win-win"
approach makes it a positive and instructive experience for both
Woodside Fund will work with you to determine an appropriate valuation
for your company. It’s not something you have to figure out on your
own. Simply put, the value of a company is what drives the price
investors will pay for a piece of the action. The information used
to determine valuation comes out of the due diligence process, and
has to do with the strength of the management team, market potential,
the sustainable advantage of the product/service, and potential
financial returns. Another way to look at valuation is how much
money it will take to make the company a success. In the end, the
value of a company is the price at which a willing buyer and seller
can complete a transaction.
Ownership and valuation is typically calculated on a fully diluted
basis. This means that all securities, including preferred stock,
options and warrants, that can result in additional common shares,
are counted in determining the total amount of shares outstanding
for the purposes of determining ownership or valuation.
Type of Security
Investors typically receive convertible preferred stock in exchange
for making the investment in a new venture. This type of stock has
priority over common stock if the company is acquired or liquidated
and assets are distributed. The higher priority of the preferred
stock justifies a higher price, compared to the price paid by founders
for common stock. "Convertible" means that the shares
may be exchanged for a fixed number of common shares.
When the company is sold or liquidated, the preferred stockholders
will receive a certain fixed amount before any assets are distributed
to the common stockholders. A "participating preferred"
stockholder will not only receive the fixed amount, but will also
share in any additional amounts distributed to common stock.
Dividends are paid first to preferred stock, and then common
stock. This dividend may be cumulative – so that it accrues from
year to year until paid in full, or non-cumulative and discretionary.
Preferred stock may be redeemed or retired, either at the option
of the company or the investors, or on a mandatory basis, frequently
at some premium over the initial purchase price of the stock. One
reason why venture firms want this right is due to the finite life
of each investment partnership managed by the firm.
Preferred stock may be converted into common stock at a certain
conversion price, generally whenever the stockholder chooses. Conversion
may also happen automatically in response to certain events, such
as when the company goes public.
The conversion price of the preferred stock is subject to adjustment
for certain diluting events, such as stock splits or stock dividends.
The conversion price is typically subject to "price protection,"
which is an adjustment based on future sales of stock at prices
below the conversion price. Price protection can take many forms.
One form is called "ratchet" protection, which lowers
the conversion price to the price at which any new stock is sold
no matter the number of shares. Another form is broad-based "weighted
average" protection, which adjusts the conversion price according
to a formula that incorporates the number of new shares being issued,
and their price. In many cases, a certain number of shares are exempted
from this protection to cover anticipated assurances to key employees,
consultants, and directors.
Preferred stock has a number of votes equal to the number of
shares of common stock into which it is convertible. Preferred stock
usually has special voting rights, such as the right to elect one
or more of the company’s directors, or to approve certain types
of corporate actions, such as amending the articles of incorporation,
or creating a new series of preferred stock.
Right of First Refusal
Holders of preferred stock typically have the right to purchase
additional shares when issued by the company, up to their current
aggregate ownership percentage.
Founders will often enter into a co-sale agreement with investors.
A co-sale right gives investors some protection for investors against
founders selling their interest to a third party by giving investors
the right to sell part of their stock as part of such a sale.
Registration rights are generally given to preferred investors as
part of their investment. These rights provide investors liquidity
by allowing them to require the company to register their shares
for sale to the public -- either as part of an offering already
planned by the company (called piggyback rights), or in a separate
offering initiated at the investors’ request (called demand rights).
Vesting on Founders’ Stock
A percentage of founders’ stock, which decreases over time, can
be purchased by the company at cost if a founder leaves the company.
This is a protection for the investors against founders leaving
the company after it gets funded.
To learn more about Term Sheets and valuation, you may want to
take a look at these books:
The Silicon Valley Way by Elton B. Sherwin
The Small Business Valuation Book by Lawrence W. Tuller
Guide to Business Valuations by Jay Fishman