In a prior Inceptiv blog post, we talked about steps a company can take before signing a term sheet.
In this two-part blog post, we dive in deeper, and review some key terms that you as a founder/company should focus on when negotiating a private company, preferred stock, priced round financing term sheet.
As previously noted, while most companies are eager to capitalize on the momentum of the deal and want to sign the term sheet right away, it is important for companies to take the time to review and consider the following terms, some of which are clearly important, whereas others may have an important impact on the financing and your company in less obvious ways.
1. Valuation – Amount
Valuation, along with the size of the round, is often the “headline” number that founders focus on when negotiating a term sheet, and for good reason. Valuation in many ways is a direct quantification of the “value” of the company overall, and founders are understandably proud the larger the valuation gets.
Obviously, the higher the valuation, the better for a company or founder, and the less dilution existing stockholders will experience for a given amount raised from investors. However, there are a few things to consider.
First as discussed further below, is the valuation pre vs post money? While founders will often gravitate towards accepting a post money valuation as it will typically look “bigger” given it includes the amount raised as part of the valuation, in many cases a pre-money valuation will be more favorable and may result in less dilution.
Second, valuation, while important, is still just one of many terms for founders to consider – in some cases, it may be more advantageous for founders to consider a term sheet with a lower valuation where other terms are more favorable.
Finally, having a high valuation is not the end all – be all. It may raise the stakes with respect to expectations for future rounds and/or an exit – essentially “raising the hurdle” that founders need to exceed to be considered successful.
2. Valuation – Pre vs Post Money
As noted, not all valuations in term sheets are the same – one of the key questions is whether a valuation is determined on a “pre-money” basis or on a “post-money basis” (often referred to colloquially as “pre” or “post” valuation)? These days, especially in the more investor favorable environment that currently prevails, most term sheets specify “post” money valuations.
Investors tend to favor post-money valuations, as it is inclusive of the amounts raised so that the investor is clear on what % of the company they are purchasing.
On the other hand, a “pre” money valuation does NOT include the amounts raised, such that the % an investor will receive for a given investment is only determined once the total amount raised is set.
Post Money Example: A total investment of $20M on a $80M POST money valuation means such investor(s) will receive 25% of the Company ($20M out of $80M post money).
Pre Money Example: A total investment of $20M on a $80M PRE money valuation means such investor(s) will receive 20% of the Company ($20M out of $80M pre + $20M investment = $100M total POST money).
As you can see, comparing different term sheets with both pre and post money valuations will require assumptions around the total amount that will be raised, and as is the case above, sometimes a lower pre-money valuation works out to the same dilution or less dilution than a higher post money valuation.
In addition, changes in overall round size will impact a company differently depending on whether they have set a pre or post money valuation. Where the amount actually raised is HIGHER than the original target round size, a POST money valuation where result in more dilution experienced by the company vs a PRE money valuation.
Using a similar example:
Post Money Example: Despite a total target investment of $20M on a $80M POST money valuation, the company ends up closing on $25M. In such case, the investor(s) will receive 31.25% of the Company ($25M out of $80M post money), a 6.25% increase in dilution.
Pre Money Example: Despite a total target investment of $20M on a $80M PRE money valuation, the company ends up closing on $25M. In such case, the investor(s) will receive 23.8% of the Company ($25M out of $80M pre + $25M investment = $105M total POST money), or only a 3.8% increase in dilution. The increase in dilution in the pre money example is less, in part because the final post money has increased by the amount of increase in the final closing amount.
3. Round Size
Round size – the total amount the company is targeting to raise – may seem a fairly straightforward concept. For most companies, often, the more raised, the better.
However, there are some considerations in thinking about the appropriate round size, including review of existing pro-rata rights provisions that will require review by company counsel.
Company Needs. One of the obvious considerations is the amount of cash that a company needs to continue to operate. For most venture backed companies, an initial financing is just a first step towards future financings, and so founders should think about what progress or milestones it will need to be able to show to justify the next financing and/or a higher valuation, and work backgrounds as to the time and resources needed to reach that milestone (plus some buffer), and the likely burn during the period, to determine the amount they need to raise.
Dilution. In addition to the cash burn/needs of a company, founders should consider the amount of dilution they are willing to take. A general rule of thumb is that most companies should expect at least 25-35% dilution at each round (inclusive of dilution from the investment itself and any employee option pool reloads as further discussed below) although this may lessen at later financing stages.
Investor exposure. Round size is also often dictated by investors (lead investors in particular) who, when making an investment, are looking to purchase a certain level of equity ownership in a company.
Follow-on investors. Typically companies will want to make room for non-lead or “follow-on” investors, who may be smaller funds, strategic investors, or others that the company would like to have as investors. For “hot” companies, this can be a “good” problem where the round is oversubscribed and needs to be adjusted to accommodate additional investors.
Pro-rata rights. Companies that have granted pro-rata rights (also known as rights of first offer or pre-emptive rights), whether via a side letter or an existing investor rights agreement, will need to account for such potential investment or seek an explicit waiver of such rights. It can be a good idea for founders to contact counsel to review existing side letters and/or investor rights agreement(s) to confirm whether such rights exist, and perform calculations to understand what portion of a round may be subject to pro-rata rights prior to setting the overall round size.
4. Type of Security, aka “what do I call this round”?
A common question that founders ask is “what do I call this round”, e.g. is this a “Seed” Financing, a “Series A” financing, etc.
Perhaps 20 years ago, a “seed” round might be a round where less than $1M was raised, largely from angels or individual investors, and the “Series A” round might be the first priced round financing with an institutional/VC investors, usually in the amount of $3M-$5M at a sub $20M valuation. However, over time, the terms have morphed and become more flexible, and the trend has been towards large rounds with higher valuations.
There are no specific legal definitions or requirements that govern whether a particular financing is called a “Seed” vs an “A”, including what valuation or what round size should apply to each label. However, founders should consider discussing the round name/security type with investor and company counsel to ensure all parties are aligned.
5. Lead Investor vs Co-Leads
Ideally the Company has been talking to a number of potential investors, trying to find a good fit and the best deal. In the process, hopefully one or more investors are interested enough to issue a term sheet, thus acting as a “lead” investor who will set the terms of the round.
In some cases two or more investors may agree to act as co-leads on a term sheet (possibly investing a similar amount). In co-lead situations, companies should ask about whether they will be responsible for two legal fees (see below regarding legal fees) and whether both sets of investor counsel for each investor will be point on the financing document review and due diligence, or if just one of the two investors’ counsel will be taking the lead on such review – in some cases having two investor counsels involved may slow a deal down and/or increase costs.
6. The amount the Lead Investor is committing to Invest
Typically, a founder should expect that a term sheet will specify the amount the Lead Investor will invest in the round, often expressed as either a “target” amount or sometimes expressed as both a target and a “minimum” amount to be invested by the Lead. To the extent this is not specified, you should include it in the term sheet, as it is helpful for both planning the allocations in the overall round, as well as clarifying exactly how much the lead is intending to invest. In addition, in some instances, a term sheet will also specify a maximum amount, as the company will want to be sure that there is enough room in the round for other investors the company wishes to have participate, as well as room for investors exercising their pro-rata right.
7. Minimum Initial Closing Amount
Many term sheets specify a “minimum” initial closing amount that the company and lead investor(s) will close on as part of an initial closing. In some cases it may be advantageous for the company to include such a term, to ensure that it knows that the financing will still close so long as such threshold is met, even if the total target amount is not met and/or there are not enough investors to follow-on at the initial close.
8. Employee Stock Option Pool Size/Reload
Investors typically ask that the company reload its employee option pool to a particular percentage of the post financing/post close capitalization table. This is usually expressed as a certain percentage of the fully diluted capitalization or “cap table” available for issuance post close.
The amount targeted for the reload has a direct impact on the dilution that a company and its founders will experience in a financing round.
The reasons investors insist on this is to ensure there is enough equity available to issue to new employees post financing without further diluting the investors. Term sheets will typically include language that such increase will be issued as part of the PRE-money capitalization (even if calculated/targeted on a post financing %), such that it will NOT dilute the investors participating in the round.
For an early stage priced round financing (Seed or Series A), a 10% pool post close is typical (note, this is the amount available, not the overall size of the pool, and hence will take into account options already issued out of the pool or promised but not yet granted). However, percentage is always open to some negotiation (typically companies/founders will try to negotiate this down to decrease the potential dilution in a financing).
There are various reasons to justify a target pool percentage lower than 10%, which can be discussed with your counsel.
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