by Tom Taulli
The ownership percentage varies based on a variety of factors. One is the general funding environment. If it’s robust—like the late 1990s or 2010 to 2012—then expect the ownership percentage to be 10% to 15%. But if the market is in a nuclear winter, such as during 2001 to 2003, then it could be 30% to 40%. This is assuming any investors are willing to write a check.
The other critical factor for the valuation of the company is its hotness. If you have what appears to be the next Facebook, then expect multiple term sheets, all with minimal valuation percentages (they could easily be below 10%). But for this to happen, you need to have tremendous traction in the marketplace already.
The more likely scenario is that there will be naysayers. VCs will try to get a better ownership percentage by highlighting the risks. This is why you need to constantly find ways to hit milestones and show ongoing progress. It’s the only way to get a blow-out valuation.
Types of Valuations
To negotiate the valuation, you first need to understand the lingo. Keep in mind that there are two types of valuations: pre-money and post-money.
The pre-money is the valuation of the company before any capital is added. Suppose you start a company, and, based on your analysis, you think it’s worth $5 million. This is the pre-money valuation.
Let’s say an investor agrees to this amount and is willing to invest $1 million. In this case, the post-money valuation is $6 million, which is the pre-money valuation plus the investment amount.
As you can see, the difference between the pre- and post-money valuations is $1 million, which is significant. This is why you need to be clear with the VC about which one is being discussed. If not, you may wind up with less equity. VCs understand this and are not afraid to confuse matters to get an edge.
But there is another wrinkle—and this is mostly for Series A deals. An investor will require that a certain amount of equity be set aside for options for employees; this is called an option pool.
Again, make sure you and the investor are talking about the right valuation. Is it before the option pool is added or after? If it’s the former, you will suffer from dilution over time as you grant options. This can be a big deal, because option pools typically range from 10% to 20% of the outstanding shares. In the case of the Series A funding of Facebook, the company and the VC agreed to share the dilution of the option pool. It was a reasonable approach.
If this is not possible, you can try to get a higher pre-money valuation. But this has its limits as well. Unless you have a red-hot startup, you may not be in a position to get aggressive about the valuation.
Finally, you need to understand that there are valuation differences for the types of securities involved in the financing. In general, common stock is valued at 10% of preferred stock, because the preferred stock has more power. Although this may seem a bit unfair, it’s actually a benefit to the company. A lower valuation on the common stock makes it easier for employees and founders to buy shares, because they are much cheaper.
The 10% rule is also a way to avoid tax problems. For example, let’s say the common stock is sold at 1 cent per share to the founders. Six months later, they sell shares to angels at $1 per share. In this case, the IRS will wonder if the original valuation was too low, and the founders may have to pay a huge tax bill. By having separate valuations for the common and preferred stock, you can avoid this problem.
Critical Deal Terms
Don’t get deeply mired in all of a term sheet’s clauses. Many are not particularly important and are a waste of time. When getting funding, you want to maintain momentum and close the deal quickly so you can begin the next phase of the company’s growth.
Speed is also important because the funding environment can freeze in an instant. Take the example of PayPal. The company’s CEO, Peter Thiel, rushed to close a $100 million funding in March 2000 because he thought the dot-com bubble would burst. He turned out to be prescient: the market collapsed in a few days. Without the funding, PayPal would have been out of cash in about two months.
There will inevitably be disagreement, but the most important clauses in a term sheet include the liquidation preference, the board slots, anti-dilution, pay to play, and drag-along rights. Let’s look at each in more detail:
Liquidation Preference
The liquidation preference gives priority to the investor when there is a liquidity event, such as an acquisition. The most basic is a 1X preference. This means the investor gets up to 1 times the investment back before anyone else gets any cash.
This is a reasonable provision. To understand it, here’s an example. Jack raises $5 million for his startup. After a few months, he gets bored with the venture and shuts down operations. He walks away with a big chunk of the money because he owns more than a majority of the stock. It’s sounds awful, but it’s perfectly legal.
Because of this potential scenario, you have no choice but to accept a liquidation preference. Even Facebook had to.
The good news is that you can soften the impact. If an investor demands a 2X or 3X or even 4X preference, push back hard. It could mean you wind up with absolutely nothing even if your company turns out to be a success.
For example, suppose you get a $10 million investment, but there is a 3X liquidation preference. If you receive a $30 million buyout, all of it goes to the investors. In the end, you will have been an employee, not an entrepreneur.
A VC may try to extract even more with something called a participation, which gives them part of the upside as well. Let’s take another example. Suppose you raise $10 million for your venture, but the investor gets a 1X liquidation preference and participation. His ownership percentage is 30%.
After a year, the company is sold for $20 million. The investor gets the $10 million back plus 30% of the remaining amount, or $3 million. The remaining $7 million goes to the rest of the shareholders.
As you can see, a participation clause can take a big bite from a transaction. As much as possible, try to eliminate it from the term sheet.
If this is not possible, try to get a cap. For example, you may agree that the amount of the liquidation preference and the participation may not exceed 2X the initial investment.
In the Series A stage, it’s easy to get a sense of the impact of the liquidation preference and participation. But with Series B and subsequent rounds, the math can become complicated, because there will likely be multiple preferences and participations. Thus it’s a good idea to have a spreadsheet to test the myriad alternatives. You do this by using a capitalization table (or cap table for short). It lists all the shareholders in a company and makes it easy to see how changes will impact the equity percentages. Your attorney should provide such a table.
Board of Directors
All C-Corps have a board of directors, which can range from three to ten members or so. They often meet every month or two to review the company’s progress and weigh-in on strategic decisions.
But the board is more than a source of advice. It also has lots of power. Consider that it can appoint and fire the CEO. This is why VCs negotiate hard to get as much power as possible over the board seats.
Zuckerberg saw this as something to avoid at all costs. To realize his vision of a global powerhouse—which would involve holding back on advertising deals, saying no to mega-buyout offers from companies like Yahoo, and deferring an IPO—he knew that he had to maintain control of the board.
Zuckerberg also had the advantage of getting valuable advice from Sean Parker on the matter. Parker was kicked out of the company he founded, Plaxo, because he didn’t have enough control over the board. And he also got kicked out of Napster!
To avoid this result at Facebook, Parker recommended that Zuckerberg set up the corporate governance to give him power to name three out of the five board seats. The other two went to Peter Thiel, who was known to be founder friendly, and Jim Breyer, a partner at Accel.
It wasn’t until June 2008 that Zuckerberg made a move to elect an outside bo
ard member: Marc Andreessen. Back in the mid-1990s, Andreessen ignited the Internet revolution with the Netscape browser. Zuckerberg instantly confided in Andreessen because he had first-hand experience of the challenges of being a 20-something wunderkind.
Then, in March 2009, Zuckerberg brought on another key board member: Donald Graham, CEO of The Washington Post. They became good friends and shared a deep sense of the importance of creating a company that is built to last.
The lesson is not to rush things. Doing so only adds to the complexity and, even worse, to a loss of control. Spend time getting to know potential board members and developing a feel for their philosophies on major issues.
Some VCs may request an observer seat for board meetings. It’s tempting to agree, because you won’t lose any power. But you should still say “No.” For the most part, an observer only adds to the distractions at board meetings.
In terms of compensation, a board member usually receives stock options instead of cash, as well as reimbursement for travel and out-of-pocket expenses. But be careful. The reimbursements must be reasonable. You don’t want to pay for the gas in a VC’s jet!
Anti-Dilution
A down round is horrible. This happens when the next series of funding is at a lower valuation. Existing shareholders usually take a hit, and employees and founders also feel lots of pain. It can be so bad that key people decide to leave, putting the venture in jeopardy.
A VC anticipates this possibility and puts in place protections known as anti-dilution clauses. The problem is that the founders and employees don’t get these protections.
Even though this seems unfair, it doesn’t matter. Anti-dilution clauses are standard features in a term sheet.
But there are ways to lessen the pain. To understand how, you need to know about the different types of anti-dilution clauses.
The most severe is the full ratchet, which triggers the issuance of new shares to an existing investor and reduces the price of the prior financing to the same price as the current round. The result is that the founders see massive dilution. If this occurs, it’s best for a founder to leave. The down round will already have created a major loss in confidence, and the investors probably want you to leave anyway.
The other type of anti-dilution clause is the weighted average approach. It involves a convoluted equation that blends a lower price and new shares issued. Basically, it lessens the severity of the dilution’s impact for the founders. The level depends on the formula, which has two flavors: broad-based and narrow-based. The math is beyond the scope of this book. But as a general rule, the broad-based approach is best for entrepreneurs. It still has a sting but is tolerable.
Pay-to-Play
For the most part, you want existing investors to participate in future rounds because it’s a telling sign of their confidence in the company. It also helps to promote continuity. It cannot be stressed too much that your investors are key partners in your company’s success.
To encourage future investments, you can include a play-to-play provision in the term sheet. If the investor doesn’t invest, preferred stock converts into common stock. This means the investor loses key advantages, such as the liquidation preference and the anti-dilution clause.
You probably won’t see a pay-to-play provision in the initial term sheet. It’s up to you to bring it up and highlight how it’s important to the deal. You can say something like, “Aren’t you interested in the long-term prospects of the company? Why not invest in the future rounds?”
If there is still pushback, you need to reconsider the investor. Will they be there when times are tough?
A pay-to-play provision may not be appropriate for angels, though. They are using their personal funds and may not want to feel obligated to keep funding the company. Out of deference, you may want to leave such a provision out of the term sheet for the angel round.
Drag-Along
A drag-along provision requires founders and other key shareholders to vote in favor of a major corporate transaction, such as a sale or merger. It can make for a self-fulfilling prophesy. For example, suppose XYZ invests $10 million in ABC and has a 3X liquidation preference. Microsoft comes along and offers $20 million for the company. The VC wants to get a quick return for their portfolio—because their other investments have been lagging—and agrees to the deal. If there are drag-along rights, everyone else must do so as well. But the problem is that all the other shareholders will get nothing.
In other words, founders should negotiate this hard. Keep in mind that Zuckerberg didn’t have a drag-along clause in his financings.
If you cannot knock out the clause completely, there are some ways to soften it. One is to require majority approval from the common stock holders. If investors complain, say that the preferred stock holders have the option to convert to common stock.
Another helpful clause is to require a minimum valuation on the deal. It could be something like 2X the liquidation preference.
Not-So-Important Clauses
Now let’s look at clauses that are not essential. Although you should put up some resistance to them, you need not spend too much effort on it. Save your time for the clauses already discussed.
Conversion Rights
This clause involves the conversion of preferred stock into common stock. One approach is an optional conversion right, which gives a preferred stock holder the discretion of whether to convert their stock. Often this is done when maximizing the value from a liquidation preference.
Huh? To understand this, let’s take an example. Suppose ABC invests $10 million in XYZ and gets 20%. The preferred stock has a 1X liquidation preference, but there is no participation.
After a few years, XYZ sells out to Facebook for $100 million. ABC gets only $10 million with the liquidation. Thus, a better option is to convert the preferred stock to get 20% in common stock, which amounts to $20 million (this is known as on a converted basis).
In some cases, there is a mandatory conversion right. This means a conversion takes place as a result of a certain event, which is typically an IPO. It’s much cleaner for a public company to have only common stock.
A mandatory conversion has a threshold amount, which is the minimum that needs to be raised in the public offering. For a startup, it’s important to set this threshold as low as possible. For example, if there is a conversation at $100 million, this may give an investor leverage to negotiate better terms or more equity. But if the amount was instead $20 million, the conversion would be automatic because most IPOs exceed this amount. In fact, if the amount is less than $50 million, you should not have much of a problem with the mandatory conversion clause.
Redemption Rights
Some companies are known as the “living dead,” which means they have little growth potential. VCs don’t have much opportunity to see outsized gains in such cases.
Yet they may want to get their money back. This can be done with a redemption right (or a put), which allows an investor to require a company to repurchase shares after a fixed period of time. Despite this, the redemption right may be useless because the company may not have enough cash on hand to buy back the shares.
If you cannot eliminate the redemption right in a term sheet, you should push back on the time limit—say, providing for five years or more. You should also not tie it to a “material adverse change” clause (this is when a major event happens, such as an earthquake or a terrorist incident). It’s important to limit the redemption right to the initial investment amount, which doesn’t include any dividends.
Dividends
A dividend is a distribution of cash from a company to its investors. It seems strange for a startup to have such a clause; dividends are supposed to come out of a company’s profits, which probably don’t exist for a startup.
Some dividends are cumulative. This means that if a dividend isn’t paid, it accumulates in a reserve account. No other investor gets a payment until these dividends are paid off. You should definitely fight a
gainst cumulative dividends.
A non-cumulative dividend means a board must declare a dividend. If not, then there is no payment for the year. And yes, this is much better.
No Shop
From a legal standpoint, a term sheet is non-binding. Both parties can walk away from the deal at any point, without consequence.
Yet this isn’t likely to happen. In the investing world, reputation is vitally important. A VC doesn’t want to be known for leaving a company at the altar. At the same time, an entrepreneur doesn’t want to be considered flaky. After all, they most likely need to keep raising money.
There are some provisions in a term sheet that a VC wants to make binding. One is the no shop clause. This forbids a founder from actively seeking out another term sheet after an agreement is reached.
The VC may try to set this at 90 days or more. But you should have a period no longer than 30 days.
Protective Provisions
These are veto rights for investors. It doesn’t matter what the board says. A vote from the shareholders doesn’t matter either. A protective provision always trumps everything else.
Certain standard provisions probably can’t be negotiated away, such as the following:
Sale of the company
Amendments to the certificate of incorporation or the bylaws
Changes in the total number of authorized preferred and common stock
Issuances of new securities that have preferences over existing preferred stock
Redemption of preferred shares or common stock