This is the fourth post on Term Sheets and how they impact returns to investors. In addition to economics and control, term sheets also contain provisions that impact how as investors we can add some level of protection for the value of our investment. Although there are a number of provisions in the term sheet addressing this, the three most important to me are:
- Information Rights
- Pre-emptive Rights
- Anti-dilution Provisions
Information Rights: Subsequent to writing the check, it is important to me to get periodic updates from the company on both how things are progressing and what the financials look like ( versus the projections at the time of investment). It is important to read this term carefully to determine what information will be provided, what is the frequency of communication and just as important WHO is entitled to get that information. Some term sheets will contain provisions that limit these rights either to a certain investor class(es) or to those investors owning a minimum % of outstanding shares.
Pre-emptive Rights: This provision enables certain shareholders to purchase shares in a subsequent offering, prior to offering those shares to new investors, in order to maintain their current ownership percentage. It is important to carefully review this clause to see if it contains what is known as a “pay to play” clause which requires that those shareholders actually exercise their right to purchase shares in order to continue to maintain these pre-emptive rights in subsequent rounds of financing.
Anti-dilution provisions: Although we all hope that subsequent investment rounds will be done at ever increasing valuations, all of us have at one point or another experienced the dreaded “down round“. Whether it’s missing sales targets or having a new competitor enter the market….one of the protections that can be built into the term sheet are anti-dilution provisions that enable the investor (typically the preferred shareholders) to in essence reset the conversion price of their shares in the event that a follow-on round is done at a lower valuation. These anti-dilution provisions typically allow for either a “full-rachet” – if the new investors are investing let’s say at $1.00 per share and we had made the investment at $1.50 per share our conversion price would be reset to $1.00 per share. Our “value” under the full rachet would remain the same as we would make up in additional shares the reduction in the original purchase price. The common shareholders would not be provided with this provision and the value of their shares would reflect the new price ( in this case a reduction of 1/3 of the value).
As an alternative, many term sheets may provide for a “weighted average” method to determine the new conversion price for the preferred shareholders. This price, using the example above would be somewhere between the new price of $1.00 and the $1.50 we paid for our shares. The new price would be calculated by using a formula which sets the discount percentage to be applied to the original purchase price. Without going into all the formulas, these methods can be characterized as “narrow” or “broad” with the difference being the types of equity securities that are counted in the calculation. Some term sheets will provide for a “full rachet” for a certain period of time post funding and then a weighted average method after that.
As with any document, it’s important to read the fine print!