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Sunday, November 15, 2009

Reading and 'Rithmetic...Demystifying Term Sheets and Cap Charts

Entrepreneurs have a lot to deal with in creating their business - from coming up with a product to creating a compelling marketing message to finding the right buyers for their product, and unless they're lucky, have wealthy family members, or are independently wealthy in order for them to do all these things they need to raise money from Venture Capitalists or Angel investors. That in turn means at some point in the evolution of their business they'll need to deal with term sheets and cap tables. And that was the focus of our last TLP Boston session - understanding the ABC's of a term sheet, what is negotiable and what is not, and how to understand a cap table.

For our session we had two partners from the law firm Edwards Angell Palmer & Dodge (EAPD), Richard Kimball and Gregg Ploussios lead us through the basics of interpreting a term sheet, and one of our own fellows Steve Meyer along with an associate of his, Jameel Khalfan from Globspan Capital, lead us through an exercise in filling out a cap table.

As Richard and Gregg pointed out, term sheets can be daunting to entrepreneurs containing many different bullets that outline the terms of a deal. However, there are a few key items in a term sheet that an entrepreneur should pay attention to -

PreMoney Valuation:
Most entrepreneurs focus on this when looking over a term sheet as it is the most easily understood part of a term sheet, and the one that determines the ownership percentage that an investor will take with their investment. The basic idea works like this - an investor puts a value on the company in dollars before the investment is made, and the terms indicate how much money the investor will put in at that valuation. Dividing the investment by the pre-money valuation plus the investment yields the percentage ownership an investor gets. So as an example if an investor says your company is worth $1M pre-money and will put in $1M in investment, then after the investment the total value of the company is $2M. Therefore the investor with his investment has taken 50% of the company. Depending on the stage of a company the pre-money valuation of a company and the amount invested will vary greatly. The key to remember for an entrepreneur, as opposed to focusing solely on the valuation, is to make sure the investment will get the company to a point where when more money is raised the valuation will be much higher or even better the company won't require more investment. Of course that doesn't mean an entrepreneur should do their best to negotiate as high a pre-money valuation as possible.

Liquidation Preferences:
Liquidation preferences are often quite confusing when they are read through on a term sheet, but in actuality they are quite simple. A liquidation preference simply indicates how an investor will be paid out in the event of a liquidation event. There are two typical types of liquidation preferences - participating preferred and non-participating preferred.

In a participating preferred scenario, an investor gets to "double dip". They get a fixed multiple of their original investment and then the remainder of the proceeds are divided on a pro-rata basis amongst the stockholders AND investors. So as an example suppose an investor invests $5M and takes 50% of the company with their investment. If the company sells for $20M, then an investor with a 1X participating preferred preference will receive $12.5M total before anyone else receives any money (their $5M original investment and since they own 50% of the company an additional $7.5M of the remaining $15M).

In a non-participating preferred arrangement an investor only receives their percentage ownership of the company (or in the case of a sale that results in less than double their original investment they get their original investment back). So in the same scenario above the investor would only receive $10M for a $20M sale.

And the rest...
There were quite a few other items covered as well -
  • anti-dilution protections - These protections are put in place in the event that the company has to issue securities at a purchase price less than the purchase price of the current class of securities.
  • protective clauses - These clauses prevent the company from issuing new security classes without obtaining written consent of the majority of the current class of security.
VC Mathematics (does 1+1 still equal 2??)
After our session on term sheets Steve and Jameel took us through some concrete examples on filling in a cap table. I'll spare everyone the math lesson, but there are a few key things that we learned in the exercise that is important to creating a cap table -
  1. The first step involves listing the shares and various percentage ownership stakes each stakeholder has in the company currently (stakeholders could be option holders, founders, and investors).
  2. The second step is to figure out the post-money valuation of the company after investment and what percentage of the company that investment will get the new investor who's coming in.
  3. Third it is necessary to calculate the total number of shares that will exist after investment. This is based on the existing number of shares, the post-money valuation, the size of any option pool, and the percentage of the company the investor will own after investment.
  4. Finally after the number of shares is calculated then a share price is reached.
In Conclusion
While term sheets and cap tables are not the most exciting part of a business, they certainly are necessary components to building a successful startup from the ground up. This session armed us with the tools needed to understand how the value of a startup changes over its lifetime and how to quantitatively evaluate different options when it comes to investment.

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