By Sandy Carter. Whatever side of the political fence you prefer, former Pres. Reagan’s quote, “Trust, but verify,” is not only a clever adoption of a Russian proverb, it also provides good advice for company founders who are reviewing an investor’s term sheet.
An investor agrees to put money into your company. He’s a nice guy, maybe you met him at a wedding or he’s your new brother-in-law. Either way, you can trust him, right? Don’t they call those guys ‘angels?’ Whether he’s an angel investor or a venture capitalist and a wonderful relative, ‘trust, but verify.’
Ask for a Term Sheet
Why ask for a term sheet? For clarity! Clarity will help you avoid misunderstandings, which is important with investors and imperative for friends and family. Before you sign on the dotted line, review the term sheet – the preview of the agreement you are about to make with the investor. A term sheet outlines some very important variables including:
- Pre-money valuation: the worth of the company before the funding round
- Investment: amount raised in the round from this investor
- Option Pool: shares earmarked for future employees
- Price per Share: calculated from other parameters
- Dilution: calculation of what your investors own before and after the round
- Other ‘fine print’ items such as liquidation and other preferences, anti-dilution provisions (designed to protect the investor in a down round), etc.
A term sheet does not sentence you to serfdom; the term sheet is a preview of the legally binding funding agreement. Terms such as a liquidation preference of 2X may seem relatively harmless, particularly when your bank account is on life support. Stop, take a breath, it’s time to ‘trust, but verify.’
Understand the Fine Print
Evaluating term sheets and the preferences they outline can be daunting. Understand the terms and use available tools to model the impact of those preferences on your current ownership and the ownership of your earlier investors. Take the wrong terms in a subsequent round and your initial investors may put a price on your head!
Some important terms you should know:
- Valuation – Pre / Post: Is your investor putting in money at pre or post-valuation? Investing $1M on a $10M pre-money valuation yields 9.1% ownership after funding, (he owns 9.1% of the now $11M company). But if he offers to invest $1M at $10M post-money, then his $1M represents 10% ownership.
- Liquidation Preference: The liquidation preference determines how the money from a liquidation event is distributed. For example, your brother-in-law is asking for a 2X liquidation preference. Say your $10M company is sold for $5M when your brother-in-law has 10% ownership from his $1M investment (preferred shares) and you and the other employees hold Common stock. Your brother-in-law receives 2X his investment, leaving you with just $3M to distribute among the other common shareholders. Had you done the math before taking his terms, you might still be speaking.
- Pro Rata Rights: These rights allow the investor to participate in future rounds at a prorated percentage.
- Option Pool: Including option pools in his terms, a new investor attempts to avoid major turnovers in the key talent in your company. Options are called ‘incentives’ for a reason. Equity compensation helps you to attract and retain those key individuals who can partner with you to grow the company. These option pools are often evaluated on a pre-money basis. Pools that are too large potentially dilute pre-money shares; pools that are too small leave little room to recruit good talent.
- Anti-dilution Provisions: What happens to your brother-in-law’s investment if, heaven forbid, your next funding round comes in at a lower valuation? An anti-dilution provision can revalue the shares from the previous round to ensure a specified level of ownership.
Do Your Homework
Your spouse, who is also your accountant, is raiding the children’s piggy banks to make payroll. And any term sheet looks like the congratulations letter from Publisher’s Clearinghouse. “Where do I sign,” you ask. Wait! You suddenly remember that one of the investors in your previous round was your father-in-law, an ex-Marine who takes ‘shooting straight’ literally. Now is the time to take a deep breath and run a waterfall analysis on the terms to ensure that you won’t be looking down the wrong end of Dad’s gun.
A waterfall analysis, named for the iterative nature of its calculations, models the impact to investors of liquidation events at various levels of income. These analyses examine the individual funding rounds, consider the preferences belonging to the investors and layer them to determine the outcome to each investor given an assumed liquidation value.
Modeling these outcome scenarios requires a level of expertise and proficiency, but software like Certent’s Cap Table Analytics can do the heavy lifting for you. Our web-based application graphically presents the various outcomes making it easier to explain your decision to your spouse about why you are being so mean to your brother-in-law.
Trust, but Verify
You can blame President Reagan, (you won’t be the first), or the Russian whose proverb he plagiarized. No matter. Before you take that term sheet, understand all the terms and take the time to model the outcome scenarios. You spouse will forgive you, and more importantly, you’ll survive Thanksgiving dinner with the in-laws.