Funding, the nitty gritty, post #6 of “Startup Briefs”

If you are going to take other people’s money, then you also have to know about investment structure. Will the investment be structured as debt? Equity? Convertible Debt? What about dilution? What’s the value of my company? How many rounds of funding will I need and what does that mean? How do I know if I am getting a fair deal from an investor?

This post (and the next few) will demystify some of the basic elements of investment structure to help you understand the nitty gritty of investment and how it works. We will start with stock and term sheets. Please note that valuation and investment structure will be covered in future posts.

Common stockStock.  Let’s start with the basics of types/classes of stock:

Common stock. a founder, you have common stock, which really means what is left after everyone else gets paid in the event of a liquidation or exit.

Restricted stock. If you have co-founders or early employees, some of that stock might be in the form of restricted stock, a term which refers shares in a company that are not fully transferable to the person receiving the stock award until certain conditions or restrictions have been met. You use restricted stock to make sure that the early shareholders stay committed to the company. For example, say a co-founders has restricted stock for 30% of the company which reverse vests over a three-year period. If they leave after one year, they would only have 10% the company and the extra 20% would revert back to the company. Restricted stock is still common stock.

Preferred stock. This a different stock class than common, and is what investors almost always want. As the name implies, preferred stock has certain preferences. Preferred stock has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. Preferred stock usually converts to common stock by some formula in the event of liquidity event (public offering, merger or acquisition).

Participating preferred stock. This type of stock allows shareholders to get both their money back and their pro-rata share of the common stock. So, if a person or firm owns 10% of your company, and they have participating preferred stock, in the event of an exit, they will get their investment back first and then also receive 10% of the remaining money from the exit. It’s a bit more complicated than this, but in an effort to keep this short and sweet, I am sticking to the key elements only.

Term sheet blackboardTerm sheets. A term sheet is generally a non-binding agreement that outlines an investment by a particular person or firm. Angels and venture capitalists will issue a term sheet to a company. The terms in the term sheet may continue to be negotiated as time progresses. Both the Angel Capital Association and the National Venture Capital Association have standardized term sheets that are often used. It is wise for an entrepreneur to be familiar with these resources. A few key provisions in a term sheet include the following:

Board seats. Investors will require some level of control in exchange for their investment. This will take the form of a board seat or two upon investment. For more information about boards, please read the 2014 NewVenturist blog post, “Thoughts on advisors and directors.”

Pre-emptive rights. These give existing shareholders (investors) the right to acquire new shares in a future round of financing. So, if a person or firm has purchased 10% of your company, and they have pre-emptive rights, they have the right to purchase new shares in the next round of funding to keep their 10% ownership.

Liquidation preference. This allows holders of preferred stock to get their money back (and sometimes more) in the case of an exit or liquidation before common stock holders get anything. Liquidation preference is usually referred to as a multiple: 1x liquidation preference, 2x, 3x, etc.

Anti-dilution protection. This protects investors from dilution when shares of stock are sold at a price per share that is less than the price paid by earlier investors. This is called a “down round.” Almost all venture financings have some form of anti-dilution protection for investors. There are two types of anti-dilution protection:

  • Full ratchet anti-dilution means that in a down round the conversion price of the preferred stock is reduced to a price equal to the price per share paid in the dilutive financing. The effect of full ratchet anti-dilution on the company can be very severe in the event of down round.
  • Weighted average anti-dilution is a far better deal for the company and is more common than full ratchet. Weighted anti-dilution takes into account the relationship between the total shares outstanding and the shares (or weight) held by the investor. Weighted average adjusts the rate at which preferred stock converts into common stock based upon: a) the amount of money previously raised by the company, and the price per share at which it was raised, and b) the amount of money being raised by the company in the subsequent dilutive financing, and the price per share at which such new money is being raised. The weighted average price is then divided into the original purchase price in order to determine the number of shares of common stock into which each share of preferred stock is then convertible, which will be greater than one. Thus, a new reduced conversion price for the preferred stock is obtained, which results in an increased conversion rate for the preferred stock when converting to common stock.

ball and chainProtective provisions. These are things that you can’t do without investors’ permission. They can stop forward progress so be careful of what these allow and how restrictive they are.

Tag along rights. These grant investors the right to sell shares along with founders and management and sometimes other investors.

Drag along rights. These give investors the right to force other investors to go along with a sale that meets certain conditions.

Right of first refusal. This gives investors the right to purchase shares for sale from founders and sometimes other investors.

Pay to play. This gives investors the right to force other investors to invest in future rounds.

Conclusion:  KNOW the types and classes of stock. Be smart about what equity you grant and associated restrictions and/or vesting. Know what investors will want/demand and be smart about what you negotiate. KNOW the key terms of a term sheet. And have a great lawyer at your side!

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