One of the first things a term sheet will outline is the investment mechanism for the deal. The two most common types are equity (via common or preferred shares) or convertible debt. Equity, as the name implies, is taking on investor’s money in exchange for shares. Say for example your company currently has 1,000,000 shares outstanding. You and the investors settle on a valuation of $1 per share for a pre-money valuation of $1,000,000. The investors put in $250,000 and in exchange they are issued 250,000 shares. The post money valuation of the company is $1,250,000 and investors own 20% of the company.
Investors can either be issued common or preferred shares. Depending on how your current shareholder’s agreement is written & company capitalization structure is, you will probably have all shareholders (founders) holding common shares. If investors are issued common shares, they have the same class of shares as the founders and hold the same rights. Since the investors are often the ones putting the most hard cash (as opposed to sweat equity) into the venture they will often want to protect themselves with additional rights.
This is accomplished by issuing investors a new class of shares so that their shares are of a separate type than the other shares outstanding. This allows different rights to be assigned to holders of these preferred shares. The types of conditions attached to preferred shares will vary per each situation/individuals involved. Some possible clauses attached to preferred shares to give investors greater protection are:
Liquidation preference– in the event of a company wind-up (at a loss), it can be stipulated that proceeds are first distributed to preferred shareholders and any surplus is then distributed pro-rata to all shareholders. This gives investors protection that they will be given first shot at any cash proceeds to recoup some of their investment.
Board seats – usually a set number of board seats are made available to founder’s choice, a set number of board seats are made available to preferred shareholder’s choice, and possibly a set number of board seats are stipulated to require mutual agreement. This gives investors protection that they will have a seat(s) on the board to have oversight of the company.
Voting structure – since investors usually enter into the first round of an investment with a minority position in terms of overall shares (20% in the example above), they will have limited control in terms of voting on shareholder’s resolutions as in the early financing stages of a company founders will hold a majority of the shares. And unlike in a publicly traded company, it’s not like they can easily sell their shares if they do not agree with the direction the company is taking.
Investors can get additional protection by having preferred shares vote separately or have greater voting weight than common shares. i.e. the shareholder’s agreement can stipulate that in the event of a shareholder’s motion the common shares & preferred shares vote as separate classes and to pass a motion a majority in each class must approve it.
There are many other terms that can be attached to preferred shares, if this is the deal structure the management team and investors have landed on, this will all need to be worked out during the term sheet negotiations.
The main issue with an equity investment is that it forces both sides to settle on a valuation, which as I discussed in an earlier article can be very hard to do in an early stage company. To get around this, another type of deal structure is convertible debt. Basically this treats the initial investment as debt that appears on the balance sheet. So in the example above, for the investor’s $250,000 investment they are essentially loaning the company money and the company is taking on $250,000 debit. The main feature about the debt is that it is convertible to equity. This usually is worded so that at a ‘significant’ future financing event, holders of the convertible debt can convert their debt to equity at the valuation agreed upon at the future financing event at a discount. This essentially defers the valuation question as it allows the company to take on investment, and not worry about determining a valuation until the future financing event at which time the company will be more mature, have a more predictable revenue stream, and be easier to value.
In return, investors get two upsides for making the early investment. First, the debt earns interest. The rate is negotiated between the investors and company but it is obviously going to be higher than a bank loan rate to account for the non-secured nature of the debt and risk around investing in an early stage company. Second, when investors convert to equity they convert at a discount. i.e. it will be worded that investors can acquire shares at X% of the share price set by the valuation of the significant financing event. This rewards the early stage investors for going in early and investing in the company & using their capital to help the company grow compared to the investors at the future financing event.
These are the 2 main deal structures. In my next article, I will talk about some other common clauses contained in term sheets. To view an organized index of all angel financing articles as well as see a roadmap of future articles, click here. If you have any comments or suggestions for future articles feel free to contact me: craig at mapleleafangels.com