When startups attempt to raise funding for a priced round, founders are often primarily focused on the valuation of a term sheet. This focus is not entirely unfounded. A high valuation comes with an increase in working capital for the company’s growth. The founder is also given third-party confirmation of the value of the business they created. Still, for the long-term health of the company, as well as the entrepreneur’s financial well-being, it is crucial to look beyond the valuation to the terms that come with that dollar amount.
In evaluating a term sheet, entrepreneurs need to examine the other economic provisions that impact their wealth and the wealth distribution of other investors in the event of an exit. This blog post will discuss the impact of liquidation preferences, participation rights, and anti-dilution provisions contained in most VC offers. For a further anecdotal reading on the effects of provisions in term sheets, read: How To Build A Unicorn From Scratch—And Walk Away With Nothing.
While most associate liquidation to the failure of a company, a liquidation event within the context of a term sheet includes not just bankruptcy or a wind-down of the business, but mergers, acquisitions, or a sale of voting control. The liquidation preference refers to the multiple of the initial investment stockholders are entitled to receive for a liquidation event. For example, if Series A investors invest $2 million with a 2x liquidation preference, they would be entitled to 4 million for any liquidation event. The standard liquidation preference is 1x, so founders should critically examine term sheets with higher liquidation preference multiples.
Liquidation preferences are combined with participation rights which have a significant impact on the amount founders receive in a liquidation event. Each series of investors have the right to convert to common stock. If the class of stock investors own is nonparticipating, then the investor must choose between their liquidation preference or converting to common stock. If the class grants participation rights, then investors may take their liquidation preference and convert their shares to common stock to receive the remainder of the proceeds on a pro-rata basis.
For a clear picture of how this works, let’s examine the Series A $2 million investment. Let’s say that the post-money valuation of the company is $6 million giving investors a third of the company. If the company is sold for $8 million, then investors with a 1x liquidation preference and no participation could either take the $2 million or convert to common stock. In this instance, they would convert to common stock as the $2.67 million return is higher than their liquidation preference. Now let’s examine a sale under the same fact pattern but with investors that have participation rights in addition to a 1x liquidation preference. Those investors would get their $2 million liquidation and then convert to common stock to get a third of the remainder which would be an additional $2 million. In this scenario, the investors would get half of the proceeds from the sale of the company despite only owning a third of the company. If a founder finds themselves in a position where they must accept a term sheet with participation rights, they should at least negotiate a cap on the multiple investors can receive in return.
Another critical economic term that founders should be cognizant of is anti-dilution. Anti-dilution provisions give investors the ability to protect themselves if a company later issues equity at a lower price than what they paid for in a previous round. There are two types of anti-dilution provisions, full-ratchet and weighted average. A full-ratchet anti-dilution provision can not only negatively impact founders but other classes of investors as well. Using the example of a Series A $2 million investment, if the share price is $5, then the Series A investors would own 400,000 shares. If the next round is a down round at $3/share, then a full-ratchet provision would give Series A investors shares at this lower price. So rather than 400,000 shares, these investors would have 666,666 shares, an increase of over 200,000 shares. Such a harsh term not only impacts payouts among classes of investors but the level of control within the company. This provision may also deter the next round of investors from providing financing in the first place.
A fair and more common solution would be to take the weighted average of the price of all shares outstanding. A weighted-average anti-dilution provision provides investors with the appropriate level of downside protection while also mitigating the dilution impact it would have on the founders and future investors.