5 Liquidation Preference Full Participating vs. Non

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Tony Capasso

This is the 5th post in a series of posts on understanding the basic terms of a “Term Sheet”. In this post we will talk about LIQUIDATION PREFERENCE. If you haven’t already check out my previous post it “HERE”.

In addition to the potential for preferred stock to receive dividends separate of common stock. Another reason for its preferred status is the liquidation preference.

Imagine the company going out of business you would eventually sell out all of the assets and still owe money to a bunch of people. In a simple case if there were no other bank loans, employee salaries etc. you would be obligated to first give the preferred shareholders there money (+ dividends etc.) and then if there is any left over the common stockholders would get what is remaining amount.

We are given a few options below which I will explain.

LIQUIDATION PREFERENCE

 “In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows: “

“[Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro ratato holders of Common Stock.”

We are given a new type of preferred stock terms here called “Non-participating preferred stock” This option would mean that the investors cannot “participate” the same way as common shareholders. Upon a liquidation event this share class would be paid out the amount they amount they invested (usually 1x or 2x) plus any accrued and unpaid dividends.

If the liquidation/(or sale) value is high enough than it may be more beneficial for the investors to convert the stock to common stock and lose the preferred stock status. In this case the investors get to choose the greater of either taking their proportionate share of the common stock vs. keeping their liquidation preference of the preferred stock.

For example take a company, which its preferred investors put in $1million for 10% and common stock holders own 90%. If the company were sold for $100M the preferred stockholders would get $1 million. However, if the stock was converted to common stock they would receive $10 million, which is much more beneficial. The flip side of this is if the company’s value was only $800,000 the preferred shareholders would not convert and they would receive the entire amount.

Common stock holders prefer that investors receive non-participating preferred stock over full participating, as we will see why in the next section.

“[Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.]”

In the full participating example, preferred stockholders essentially “double dip”. They are first given their original investment (1x, 2x etc.) plus accrued & unpaid dividends. Then after they are still entitled to their proportionate (pro-rata) share.

In the example above, the preferred shareholders would get investment amount (in this case 1x) of $1million plus the converted amount of $10 million totaling $11 million. In these cases things can get large. If there is compounding preferred interest along with 2x, or higher liquidation multiple things can get pretty substantial in favor of the preferred investors. That is the reason this option is most beneficial to the preferred investors. A slightly better option to the common stockholders would be as follows:

 “[Alternative 3 (cap on Preferred Stock participation rights): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]”

By placing the cap we limit the amount that the preferred shareholders get. If the value is high enough it may be more beneficial for the investors to convert to common stock. Similar to our example above lets imagine the following:

$1M investment = 10% preferred stock (1x) with a cap of (5x) the original purchase price.

If the company was sold for $100M

We would calculate this as

$1M to preferred shareholders

Plus 5x the original investment amount which is $5M

Equals a Total of $6M

In this case if the investors converted stock to common stock they would receive a greater interest.

Check out the Participating vs. non-participating spreadsheet to work out some of these models on your own.

 “A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise]. [The Investors' entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]“

Since this third option sometimes creates large “flat spots” where common stockholders could receive the same amount regardless of a range of valuations, this option clarifies and protects the preferred investors from this.

Liquidation preference can make a large difference and is particularly important to understand fully. You should consult with an expert to run out some various models with different pricing strategies.

In the next post 6, we’ll discuss “Voting Rights and Provisions” Click “HERE” to see the next post.

“Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.” 

DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.

4 Dividends & Preferred Stock

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Tony Capasso

This is the 4th post in a series of posts on understanding the basic terms of a “Term Sheet”. In this post we will talk about Dividends. If you haven’t already check out my previous post it “HERE

 Dividends:

“Alternative 1: Dividends will be paid on the Series A Preferred on an as‑converted basis when, as, and if paid on the Common Stock

Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis.

Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.”

Dividends are payments made by a company to its shareholders. When a company earns profits it can decide rather than reinvest the money (for research and development, marketing etc.) they will pay it out to its shareholders. In this term sheet we are selling a new type of share class called “preferred” stock to these investors. These “preferred share holders have different rights than the “common” stock shareholders (founders stock).

In our term sheet we are given three different options.

Alternate 1.) Dividends on preferred stock on an as-converted basis

Alternate 2.) Cumulative dividends

Alternate 3.) Non-cumulative dividends

 

“Alternative 1: Dividends will be paid on the Series A Preferred on an as‑converted basis when, as, and if paid on the Common Stock

Alternate 1.) This method would mean that the preferred shareholders only get the dividend if the common stock shareholders get a dividend. This scenario is the best for common stockholders.

“Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis.”

Alternate 2.) is a cumulative dividend option. This means that the dividends will add up if they are not paid. The percentage is based on the total amount the investor has invested. Usually startup companies reinvest the money rather than pay it out to shareholders.

For example if there were total of 1,000,000 invested and a 5% dividend then the preferred shareholders would get $50,000/year. If after 3 years the company went out of business, the preferred shareholders would be owed an additional $150,000 on top of their investment.

Cumulative dividends are best for preferred shareholders and the worst of the three options for common shareholders.

“Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.”

Alternate 3.) are Non-cumulative dividends, are paid out the same way as cumulative dividends above except they don’t compound together. Therefore if dividends are not paid out for that period then they are not added together. If one-year dividends are not paid in period one and period two but are in period three than the preferred investors will only be owed for one period. Non-cumulative dividends are a “middle of the road” option and better to common stockholders than cumulative dividends.

To wrap up, it is important to understand the balance of these three options and the long-term effects it could have. Cumulative dividends increases the amount of debt the company owes its investors while the other options are only due if the board of directors votes on it.

In part 5 of the term sheet we will discuss the meaning of the Liquidation preference section.

“Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.”

 DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.

3 Valuations, Price per Share, & Cap Tables

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Tony Capasso

This is the third post in a series of posts on understanding the basic terms of a “Term Sheet”. In this post we will talk about Valuations, Price per Share, and Capitalization. If you haven’t already check out my previous post it “HERE

Offering Terms  

Closing Date:
As soon as practicable following the Company’s acceptance of this Term Sheet and satisfaction of the Conditions to Closing (the “Closing”).
Investors: Investor No. 1:   [_______] shares ([__]%), $[_________]Investor No. 2:   [_______] shares ([__]%), $[_________][as well other investors mutually agreed upon by Investors and the Company]
Amount Raised: $[________], [including $[________] from the conversion of principal [and interest] on bridge notes]
Price Per Share: $[________] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

 

Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization).
Capitalization: The Company’s capital structure before and after the Closing is set forth on Exhibit A.

To fill out and understand these sections we must first understand Valuations. This may sound like a simple concept but it can quickly become a bit more complex. There are two sides here “Pre-money valuation” and “post-money Valuation”

“Pre-money Valuation” is the amount of money the company is worth prior to the money the investor is putting in. There are many ways to value a company, which we will not get into here, but if we know what the investor will invest and how much ownership % he wants we know can then calculate the pre and post money valuations for their offer.

“Post-Money Valuation” is the pre money valuation plus the amount of money the investor just put in.

You may have watched shows like “Shark Tank” where the investor says “I will give you $100,000 for 20% of your company” In this case the investor is offering this money in terms of the Post-Money valuation. That would mean that upon investing the $100,000 in the business worth $500,000.

( $100,000 = 20% than X = 100% answer: $100,000 / 20% = X= $500,000)

To calculate the pre money valuation in the example above you would subtract the amount the investor invested which in this case is $100,000 therefore $400,000.

($ 500,000 – $ 100,000 = $ 400,000 Pre money Valuation)

Simple Right? …. The next terms we need to understand is what are “Fully Diluted Shares”.

Stock options may be granted to an employee or affiliate in exchange for services. Imagine saying to an advisor “if you give us advice on how to grow my business I will give you the option to own 5% or 5000 shares of my company”.  In this case we have not yet issued any stock or shares to this advisor, therefore it is not fully diluted until we issue these shares.

Employee stock option plans are similar to options except that companies usually put aside shares to give to key employees. These stocks usually require the employee’s shares to “vest” over time. This means that the employees will have to work for a set amount of time in order to earn this stock, if they leave early they will not get the entire amount. This is another form of unissued or not fully diluted stocks.

Warrants on the other hand are deal sweeteners. Think of saying “if you invest in my business before anyone else I will give you an option to buy x shares of my business at a discounted price.” This also would not be fully diluted until the investor is issued the stock.

So when we discuss valuation in terms of fully diluted shares what we means we are negotiating as if all of the promised shares have been issued. Usually issued and unissued shares are displayed on a Capitalization table so that everyone is on the same page.

Price Per Share Is relatively simple. We will divide the amount of money invested by the investor by the number of new shares issued to the investor.

(Ie: if we issued 5,000 new shares for $50,000 then $50,000/ 5,000= $10 per share)

There are many resources available to help out with understanding Valuation, Price Per Share, and Capitalization tables. It is important to understand. While at first things seem very straightforward, things can get complex when there are unissued shares, and different classes of shares. Make sure you understand these concepts prior to continuing forward.

 

In part 4 of Understanding term sheets we will discuss the meaning of the Dividends section click “Here” to go to the next post.

“Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.”

DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.

2 No-Shop/Confidentiality, Exploding Term Sheets

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Tony Capasso

This is the second post in a series of posts on understanding the basic terms of a “Term Sheet”. In this post we will talk about No Shop/Confidentiality agreements, Exploding Term Sheets, and Jurisdictions. If you haven’t already check out my first post read it “HERE

TERM SHEET

FOR SERIES A PREFERRED STOCK FINANCING OF

ABC, INC.

January 1, 2050

This Term Sheet summarizes the principal terms of the Series A Preferred Stock Financing of ABC Inc., a [Delaware] corporation (the “Company”). In consideration of the time and expense devoted and to be devoted by the Investors with respect to this investment, the No Shop/Confidentiality provisions of this Term Sheet shall be binding obligations of the Company whether or not the financing is consummated. No other legally binding obligations will be created until definitive agreements are executed and delivered by all parties. This Term Sheet is not a commitment to invest, and is conditioned on the completion of due diligence, legal review and documentation that is satisfactory to the Investors. This Term Sheet shall be governed in all respects by the laws of [Delaware]

The first major item that stands out is that “No-Shop/Confidentiality” is a binding. This basically means that you agree that you will not talk to other investors about the specific terms of your agreement. For example you can’t get an offer from investor X and then go to investor Y, show him the terms and ask him to beat it.

This is a one-way street clause, by this you agree not to discuss these terms with any other investor, however the investor can continue to talk to whatever other companies they want.

We can understand that the investor doesn’t want to be spending money and legal fees on reviewing your business only to have you shop it out to other investors and then leave them hanging last minute. On the other hand, having multiple offers on the table puts the cards favorably in the entrepreneur’s hands for better terms, so limiting your options to single investors can be a bad idea prior to agreeing on the terms.

Another clause (not included in this term sheet) but worth noting is an “Exploding Term Sheet”, this would say something to the effect of “this term sheet expires at 5:00 on the day following the date of execution”

While some investors require either of these provisions, some of the more experienced ones will not. The questions to ask yourself is, “why are they only giving me 24 hours to make a decision”, “who are they afraid I will tell”, “will someone else offer me considerably better terms”, “are they offering me a fair timeframe”. With that everything is negotiable and you can simply say “this is too short a time frame for me”.

My position on this is to look for a happy balance, 24 hours may be extreme but leaving the term sheet open for weeks and shopping it out to the world is also problematic.

It is important to note that while the no shop/confidentiality clause is “binding” (enforceable), some of the remaining items in the term sheet are not. It notes that this term sheet is not a commitment to invest and is subject to due diligence etc. therefore just because you both have signed the agreement, the Investor may decide that your business wasn’t as you initially represented and they may withdraw from investing in the company. At that point if other investors know that they withdrew from your term sheet you may be looked upon, as having damaged goods, or something wrong and it may be hard for you to raise money.

The last sentence states that the term sheet shall be governed in all respects by the laws of […]. As described in the footnote, in some jurisdictions even though the term sheet says non-binding there have been cases where it becomes enforceable. In this case you may not be able to simply walk away from this agreement without putting a good faith effort to complete the deal or you an end up with a lawsuit.

Reputable investors greatly rely on their reputations to be successful. They are in the game for the long term, and therefore to be successful have to display a certain level of integrity. As with almost everything in life it is important you do as well.

Find a happy balance, be fair, honest and open about your concerns and this shouldn’t be too big of a sticking point. Make decisions swiftly and responsibly, but don’t be too eager to take the first offer that comes to table.

Please follow my next post “HERE regarding Valuations, Price per Share, and Capitalization. 

“Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.”

 DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.

1 Raising Capital and Understanding Term Sheets

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Tony Capasso

Raising capital can be one of the most defining moments in a startups companies’ life cycle. Typically, startups begin with founder(s) reaching into their own wallets to fund the business. This is commonly referred to as “bootstrapping” the business.

Usually a startup reaches a point where it needs additional resources to grow and the entrepreneur either runs out of money or needs additional “capital” to grow at a faster pace. The entrepreneur will either borrow the money (debt) or sell part of the business (equity).

They may first ask their “friends and family” to raise money although there are some limitations as follows:

Pros:

  • This group may be the only ones that believe in you
  • High level of trust, and desire for you to succeed
  • Simple terms & agreements

Cons:

  • Lower limits of capital they can invest
  • Inexperienced at business
  • Small professional network

 

When an entrepreneur reaches the level where friends and family are tapped out the next step may be to approach wealthy individuals or groups of investor. These people are referred to as “Angel Investors” or “Angel Groups” respectively. These angels invest using their own money and may or may not take an advisory approach to helping you with your business. The limitations of using Angels can be similar to those of “friends and family”. There may be only a limited amount angels are willing to invest, which may not be enough to grow the business fast enough. Angels take the chance that your business will succeed; they only make money if the business is successful.

Following angel investors we can next look to Venture Capitalists. The main difference between Angels and Venture capitalists (VC’s) is that VC’s invest money on behalf of the other people or entities. VC’s typically are able to invest larger amounts of money than angels (ie: 20+ million). VC’s will raise money from various entities such as schools, IRS’s or wealthy investors and combine the money into a “pool” and then invest the money into startups. VC’s typically make money in two ways, a management fee & a carry fee. A management fee is a percentage of the entire fund per year (ie: 2%) regardless of whether the company(s) are successful or not. This fee is justified to pay for the VC’s overhead costs like finding which companies to invest in (deal flow), reviewing financials & business plans (due diligence), etc. The carry or success fee (usually 20%) is a performance-based fee, which means that the VC will only make money based on the success of the portfolio companies.

Financing is raised in a series called “rounds” first being a “seed” round followed by series “A”, then “B”, “C” and so on. The hope is that in each round the valuation of the company increases. For example a seed round may be $50,000, followed by a series “A” round of $2 million and a series “B” round of $10 million.

After pitching your business to Friend/Family/Angel/VC etc. the next step would be to negotiate a “Term sheet.” A term sheet is supposed to be a clearly laid out list of the basic deal points. These are things like, “how much of the company am I going to get for my money”, “what happens if you go out of business”, and “do I get a say in your company.” Term sheets are generally given to an attorney after written in order to draft the final documents. As the size and rounds progress, so does the complexity of the terms and agreements.

 

The National Venture Capital Association provides a “template” term sheet, which was put together by a group of leading venture capital attorneys. (see link below)

 

http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136

 

Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.

 

DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.