In the world of fundraising, it’s not uncommon for investors and VC firms to craft term sheets that benefit themselves. For founders, knowing whether you’ve received a “clean” term sheet (one that doesn’t include things that are widely considered investor-favorable terms) can be confusing.
There’s little education around this topic for first-time founders. Many mistakes are made during seed or series A rounds—when founders are the most eager to get funding and get to work on their idea.
Here are 3 things founders should avoid to retain more upside for themselves and their employees:
- Anything above a 1x liquidation multiplier
- Participating preferred stock
- Full-ratchet price-based anti-dilution provisions
What should clean terms look like?
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Anything above a 1x liquidation preference
A liquidation preference is a key and common part of a term sheet. It ensures that if a company exits with a lower valuation than expected, the company’s preferred shareholders (i.e., the investors) will receive their money back before other shareholders receive proceeds from the exit.
Generally, the liquidation preference is set at 1x, meaning that in an exit each investor must receive their full investment back (dollar for dollar) before the common shareholders can receive anything. If the proceeds are less than the liquidation preference, then all of the proceeds go to the preferred shareholders and the common shareholders receive nothing.
If the proceeds from the exit exceed the liquidation preference by enough that the preferred shareholders would be better off converting their preferred shares to common shares and receiving their pro-rata share of the proceeds based on their ownership percentage, then the preferred shareholders will receive that greater amount.
When the liquidation preference is set above 1x, things can get dicey for founders, employees, and other common shareholders because the company has to exit at a higher valuation before the common shareholders will be entitled to any of the proceeds.
Say investors invest $2 million in a company in exchange for 50 percent of the company and they receive preferred stock with a 1x liquidation preference, here’s what the payouts would look like for $5 and $2 million exits:
|1x liquidation preference (name of chart)||Preferred Shareholders (Investors)||Common Shareholders (Founders & Employees)|
|Sold for $5 million||$2.5 million||$2.5 million|
|Sold for $2 million||$2 million||Nothing|
Now let’s say investors put in that same $2 million in exchange for 50 percent of the company but they receive preferred stock with a 2x liquidation preference. Here’s what payouts would look like for those same two exit scenarios:
|2x liquidation preference (name of chart)||Preferred Shareholders (Investors)||Common Shareholders (Founders & Employees)|
|Sold for $5 million||$4 million||$1 million|
|Sold for $2 million||$2 million||Nothing|
In the above example, because of the 2x liquidation preference, investors would get a total of $4 million out of the $5M exit, leaving just $1 million—20 percent—for founders and other common shareholders.
And if the company exits for less than the investor’s 2x liquidation preference—in this case, $4 million—the investors would receive the entirety of the payout, doubling their money even though they only own half of the company, and leaving the owners of the other half of the company with nothing.
A liquidation preference above 1x should be a warning sign for first-time founders, as countless have horror stories about how multiple liquidation preferences left them with nothing. Take, for example, Michael Arrington, founder of TechCrunch, Crunchbase, and numerous other companies. When he founded his first company, Achex, a 2x liquidation preference was the industry norm. Though he raised $18 million in capital and sold the company for $32 million—he received nothing. Thanks to the 2x liquidation preference, he had to make over $36 million to receive anything, and far more than that to receive anything substantial.
Though all founders should expect that their investors place safeguards on their investments in the form of liquidation preferences, it’s imperative that first-time founders in particular are aware of liquidation preferences that exceed 1x. Because one small number on a term sheet could be the differentiator between a founder receiving a return on the company they founded, or walking away from years of hard work with nothing.
Participating preferred stock
Preferred stock can be participating or non-participating. Participating preferred means that, when the proceeds from an exit exceed the liquidation preference, preferred shareholders will receive additional cash on top of their liquidation preference.
Say an investor invests $2 million in participating preferred stock for 50 percent of the company. If that same company were to be acquired or sold for $5 million, the investor would receive their $2 million liquidation preference off the top, and then split the remaining proceeds with the common shareholders based on their pro rata ownership (in this case, 50 percent)—which would equal 1.5 million (half of the $3 million remaining after the liquidation preference has been paid). That means the investor walks away with $3.5 million, leaving only $1.5 million left to split between all common shareholders.
Participating preferred stock allows investors to “double-dip” and receive their liquidation preference and their pro rata share of the remainder (instead of choosing between their liquidation preference and their pro rata, as is the case with non-participating preferred). This puts more money in the pockets of the investors and gives less of the upside of a successful exit to founders and employees.
Full-ratchet anti-dilution provisions
Price-based anti-dilution protection provisions adjust the number of common shares that preferred stock can convert into in the event a company later has a down round of financing. This means that the company sells new preferred shares at a price that is lower than shares of preferred it sold to its earlier investors. These provisions are designed to give investors some assurance that if the company decides to sell shares in the future at a lower valuation (commonly called a “down round”) than the valuation at which they invested, the existing investors’ percentage ownership won’t be excessively diluted by the new investment.
Price-based anti-dilution adjustments can be calculated in several ways. The most common is to take a weighted-average (which accounts for the number of shares being sold in the down round as well as the price). These adjustments can also take the form of what’s known as a “full ratchet,” which effectively reprices the shares of the existing investors with the anti-dilution protection at the down round price.
For example, say an investor were to invest $2 million for 50 percent of a company with a $4 million post-money valuation. Assuming the company had 2 million shares outstanding post-financing, the investor would have purchased 1 million shares for $2 per share. However, if the company later raises a down round priced at $1 per share, even if the Company were only to raise $20K in the round, a full-ratchet anti-dilution adjustment would entitle the original investor to receive an additional 1 million shares of common stock upon the conversion of its preferred stock. It effectively lowers the price that they paid for their shares from $2 per share to $1 per share, retroactively. A weighted-average adjustment on these same facts would result in an adjusted price much closer to $2 per share because of how few shares are being issued in the down round.
Described as “draconian” by Scott Edward Walker, founder and CEO of Walker Corporate Law and contributor to VentureBeat, it’s imperative that founders be wary of a full-ratchet anti-dilution clause in a term sheet.
What should clean terms look like?
There’s no easy way to put it. As a first-time founder, you’re vulnerable to dirty terms. Before going through the funding process, it’s imperative to not only educate yourself on the ins and outs of the process, but find good lawyers and trusted advisors. A big reason to get this right is because your first terms set a precedent and are likely to be given to later investors. As always, we’re here to help you through the fundraising process and beyond, and if you have any questions on how terms will affect you, don’t hesitate to reach out and drop us a line.
At Carta, we help startups with fundraising, compensation, valuations, equity management and much more. Talk to us to find out how we can help you grow.