Angel Investing – Term Sheet Economics

RechenschieberIn my last post, I listed four areas that Term Sheets cover. This week, I thought I would focus on some of the “Economic” terms. The terms below apply to Convertible Preferred Stock, although there are clearly other types of securities used to fund early stage companies.  These “economic” terms outline who gets what and cover such concepts as:

Valuation: For a Preferred Stock Offering, this represents the per-share price that you will be paying for the investment as well as the “pre-money” company valuation that this price implies. In addition, the term sheet will typically indicate the “post-money” valuation which includes in the company valuation the new funds being invested.

Amount of the Investment: Oftentimes the amount of investment will include both a maximum amount of the the securities being issued along with some provision for a “minimum” amount of new funds required to close on the transaction.

Dividends: Preferred Stock will usually have some amount of dividends, indicated by an annual rate,  which will “accrue” as opposed to being paid out on an annual basis. Dividends will either be cumulative – in the event the Board determines not to declare a dividend in a particular year, that dividend amount is carried forward or non-cumulative – dividends not declared in a particular year are not carried forward.

Cap Table: It is important when you are looking at an investment opportunity to understand what the current and pro-forma ownership structure of the company looks like. Make sure that it outlines not only the currently issued shares, but also any options and warrants that, on a fully-diluted basis, will impact your effective ownership.

Liquidation Preference: This can one of the more confusing concepts in early stage deals but is a very important one. In it’s most simple form, the liquidation preference sets out the order of payment among the various groups of investors. It comes into play whenever there is a  “liquidity event” which occurs whenever shareholders receive proceeds for their equity ownership in a company. A “liquidity event” can be a positive one – including a strategic acquisition or change of control of the company or on the other end of the spectrum a dissolution of the company.

Just because you own 20% of the company does not mean that you will receive 20% of the proceeds upon liquidation.

There are a few things you want to determine when reading the liquidation preference terms of a deal:

  • The preference multiple: This is the multiple of the original investment (typically plus accrued dividends) that a holder of a given series of Preferred Stock will receive prior to any distributions to holders of other series of Preferred Stock or Common Stock.
  • Participating v. non-participating: Participating preferred entitles the holder, once they have received their preference multiple, to then “participate” along with the common holders according to the percentages that that preferred stake would convert into. Non-participating is basically an either/or option – you can opt to take your liquidation preference or convert your preferred into equity and receive your ownership percentage.
  • Pari passu v. Waterfall: Pari-passu, from the latin meaning “on equal footing”, means that all Preferred Investors, regardless of the Series they represent, will be treated equally on the liquidation preference. In contrast a waterfall provision uses a “last in, first out” approach to the distribution of proceeds under the liquidation preference. Later stage preferred stock holders will receive their entire liquidation preference prior to earlier investors.

Why is this important? – if the exit/liquidation is not at a very high value, all the proceeds could end up being paid to one class of investors.

It is important to read carefully through the term sheet provisions of any investment you are considering so that you understand not only what percentage of the company your investment represents, but also how the proceeds of a sale or other liquidation will be distributed among all of the investors in the company.

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