Know your Term Sheet! (Pt.2: Economics)

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Last week I wrote about the Control part of a Term Sheet. Today, I’ll talk about the Economics of it. Disclaimer: This is part is way longer, so let’s just go straight into it.

Economic Terms involve all of those clauses that will dictate the outcome of the investment, financially speaking. At a future liquidity event, what return will the investor have and what is this return subject to?

This is the part were lawyers get to show off their elementary school math skills. Read this part carefully on your Term Sheet, and look for the following key words:

  1. Price:
    • Only your uncle calls it “Price”. Cool kids call it “Valuation” or “Cap”. Basically, how many shares you are willing to forgo in order to get that liquid cash.
      • Pre-Money vs Post-Money: This part is just elementary school math. Pre-Money is the value of the company before the investment is made, and Post-Money just adds up the amount invested into the Pre-Money Valuation. Sounds even absurd, right? Yeah, I thought so too, at first.
      • Even though it’s quite basic, be absolutely clear when discussing valuation in your term sheet. Make sure both, you and your investor are talking about the same concept (Pre or Post). Imagine signing you term sheet only to realize all this time, the VC was talking about Post-Money and you though that amount was Pre. Ouch!
      • There are many valuation methods, and I’ll discuss them in a future thread.
  2. Dilution
    • There are some tricky, sneaky ways to agree on a valuation and still get more equity. Setting up employee pools and option pools, instantly reduce the valuation under which the share of the investment will be calculated. Fully diluted is supposed to include all of this. So, talk fully diluted.
  3. Warrants
    • This is another discrete way to leverage economic terms to get more equity without directly negotiating valuation. Warrants offer the investors the right to buy shares at a strike price, sometime in the future. Many investors will add warrants on top of their shares; this will 1) reduce the valuation (unless fully diluted), and 2) give them the opportunity to get more equity eventually.
  4. Pay-to-play
    • If you want to get the benefits of the game, you gotta risk something for it. Pay-2-Play requires investors to keep investing in sub-sequent financing rounds in a pro-rata basis, to be able to enjoy their cool rights (such as liquidation preference, anti-dilution, etc.), and not get converted to common stock.
  5. Vesting & Employee Pool
    • Disclaimer: Vesting does not mean wearing Patagonia vests to the office, as Jared in HBO’s Silicon Valley does all the time. The Pool sets up a specific amount of stock options to be granted after achieving certain milestones (usually, just staying for some predetermined time in the company), to encourage early employees.
    • Vesting refers to the time frame in which those stock options will be available for employees. Traditionally, the options vest until they reach year one, and after that they vest on a monthly basis for three more years.
  6. Anti-Dilution
    • This is a special clause that protects investors from diluting, if the company happens to be in a situation where it needs to raise money at a lower valuation than before.  I wrote a blog post about Down Rounds.
    • Anti-dilution provisions protect investor, by adjusting the price at which their preferred stock is converted to common stock. There are many methods, but the most common methods are:
      • Ratchet: Very simplistic in my opinion. It means that if someone were to sell a single stock of certain series at a lower price, then the whole series would be re-priced at that lower valuation.
      • Weighted Average: Basic calculation that focuses on re-pricing the shares, depending on the percentage or amount of shares sold at that lower price. It makes much more sense (at least to me).

I’m trying to keep these posts short and concise. These are just introductions to the topic and I’ll leave the details and complexities to the pro’s.

I’m going to go ahead and suggest reading Venture Deals, again.

– VC.

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