Written by: Itay Sagie, Co-Founder at VCforU.com
You have done well, attracted an investor and you reached the pinnacle of your investment journey. You got a term sheet!
First of all, congratulations, this is no easy task, go have a beer.
Now that we have calmed down, let's take a deeper look at the term sheet and learn what you should consider and why.
For example, Common Stock vs. Preferred Stock.
Preferred shareholders have some sort of priority or extra rights over Common shareholders. These can be anti-dilution, drag along, liquidation preferences and more.
It is normally not in the entrepreneurs best interest to grant extra rights to their investors over them or other shareholders. However, this is common practice for most investors to protect their investment. Therefore there is no real way around this. It is not to say that you should not fully understand each clause and its implications before signing the term sheet. You could and should negotiate specific terms that may be a deal breaker for you, once you fully understand them. As an initial analysis, you should create an excel spreadsheet with a worst case scenario, probable case and best-case scenarios to each clause in an event of an acquisition and calculate what you and your other shareholders will gain from each scenario.
Normally the clauses have the biggest or worst effect in the worst-case scenarios. Meaning if the company sells for a smaller amount than anticipated, the founder might end up with next to nothing.
Here is an example to understand better:
Let’s say the investor has a 2X liquidation preference. (to be explained shortly)
and let’s say the investor invested $2M for 25% stake in the company (pre-money valuation of $6M).
and let’s say that you were acquired for "only" $10M and not the $100M you and your investors hoped for when closing the round.
Let’s see what happens now.
First, the “2X liquidation preference” means that investor gets 2X their investment, meaning 2x$2M=$4M. Now the remaining $6M is split between ALL shareholders.
Meaning the investor will get an extra 25% of the remaining $6M = $1.5M. So in total the investor will get $5.5M out of the $10M. If the founder has for example 10% equity at the time of the exit, they will get 10% of $6M which is $600K, after taxes you will be able to buy a nice condo.
Now imagine a worse scenario, for example, what if the acquisition was for $4M, this means the investor will get 100% of the money and the founder will be left with nothing. In the event of a success (say $100M acquisition) this won't have much effect on you as a founder and everyone will be happy. So these extra rights normally kick in and have the most effect in the "worst-case" scenarios of an exit (note that most companies don't even reach this scenario and simply have to close down, normally due to lack of capital.)
As most entrepreneurs believe their company is less likely to fail, they don’t spend too much time worried about the worst case scenario and not even the likely scenario. I truly hope they will be right, however statistics say otherwise, and investors know it better than anyone else.
To conclude, I am not saying you should reject all term sheets with preferred liquidation or other types of preferred rights as you will be more likely to dry up in terms of capital, just know what you're getting into and make well-educated decisions about the term sheet at hand.
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