By: Mark Gaeto – Managing Partner, Conrad Olenik – Associate
This is a big day! After deciding months ago that your company needed investment capital, you have spent long hours with your banker to prepare the financials, build the marketing materials, and hold presentations with your management team to a series of investors. Today you’ve opened your email to a term sheet or letter-of-intent from an interested party. Someone out there wants to write a check and buy a stake of your company. Before you pop the champagne bottles and start browsing for boats, it’s critical that you dive in and truly understand what the terms sheet or letter-of-intent is really saying. Also, it is important to understand that private equity (PE) and venture capital (VC) have different approaches and their investments will differ in their structure, but the terminology will be similar.
One big difference between venture firms and private equity is that venture firms invest in young companies and want to apply the majority of their investment towards growth initiatives, rather than letting buyers take some money off the table. Some VC firms tend to get restrictive around letting any dollars leave the business to pay off founders, angel investors, and even legal and other fees. These founders are not expected to go boat shopping; instead they’re being funded to grow fast in order to get to a future liquidity event.
In contrast, the typical private equity firm looks for more mature and cash-flow positive companies in which to invest. They seek to purchase a controlling position and will acquire over 50% of the equity in a typical transaction. A PE transaction can generate significant liquidity for the owners and allow them to reduce their personal financial risks by diversifying their net worth and preserving some level of ownership. They may also retain operational control and an operating role going forward. Browsing for boats is much more of a likelihood with PE investors.
With any investment, there are very important deal terms that you should be aware of before moving forward. This article will discuss some of the key ones.
The most important distinction to make when raising investment capital is a simple one: valuation. If you don’t know how much the company is worth, then investors are unable to purchase shares. Pre-money valuation is simply the value of a company before receiving any outside financing, while post-money valuation is obviously the inclusion of external funding or the latest round of financing. This matters when you’re looking at a term sheet stating your company is worth $50 million and the investor will be writing a check for $12.5 million and you’re trying to figure out how much ownership you’re giving up. Is this $12.5 million taken into account on top of the $50 million valuation or is it already included? In other words, is that $50 million valuation considered pre or post-money? If this distinction is not clearly defined, look at the difference in potential results below.
|Value $||Owner %||Value $||Owner %|
That 5% ownership discrepancy is worth a lot today and can be worth even more in a few years when the next investment is made. It’s a simple question that worth’s getting right immediately, especially as later rounds of financing will be benchmarked against the previous valuations. This will impact dilution as we discuss in a later section. Once the check size and the ownership percentages are discussed, the conversation will move toward the structure and type of the equity investment. In PE and VC transactions, the investors will often seek to purchase preferred shares of stock when they invest in your company, which will be senior to your common stock and include certain benefits that we’ll discuss below.
A very common aspect of these benefits include liquidation preferences. Essentially, the private equity or venture capital firms want their money out of the investment first in a liquidity event – an acquisition, an IPO, etc. VC firms will typically require a minimum of 2 or 3x return, while PE is more often 1x. Imagine a PE firm that pays $50 million for half of your business, by purchasing preferred shares with a 1x liquidation preference. This is a $100 million post-money valuation. In an upside scenario where the business sells for a high exit multiple, the liquidation preference is less worrisome for the company because while the investor gets their money first, everyone involved is getting paid well. However, in a downside scenario, it can get scary. Consider the following.
The business sells down the road for $75 million, at ¾ of its post-money valuation from the latest round of financing when the PE firm bought in. At this liquidity event, the PE investors will get their $50 million out first, even though their pro rata 50% ownership only entitles them $37.5 million. This leaves only $25 million for the company, less than 50% of the transaction size. We’ll discuss a participating preferred scenario in a later section, which will benefit the investor even more.
As illustrated above, in the event of a low or negative growth scenario where the business is not worth what it is today, investors will bake in certain downside protections to ensure their investment is “made whole” as much as possible. Aside from the inherent risk with investing in a business they only know through diligence, there’s also the chance that the owner may take his or her upfront money without consideration for the future success of the business.
Another aspect of preferred shares that enable the investors to get their money back is a simple dividend. Accruing and earning at a pre-determined discount rate, the dividend will pay back cash to the investors semiannually, annually, or at the end of the investment. These dividends are not designed to ensure a large return for the investor, but rather mitigate the risk in a downside scenario and keep cash flow consistent during its life. Mathematically, the larger the investment amount and the lower the expected exit multiple, the more the dividend matters. Some quick calculations can show just how much these dividends can matter. Consider an investor who buys $50 million of preferred shares with a 10% cumulative dividend. By calculating simple interest, this is an extra $5 million due to the investor every year. At the sale of the company in 5 years, their $50 million investment is already worth $75 million. If the interest is compounding annually, that amount is just over $80.5 million. All in all, this represents a significant benefit to the investor who holds the preferred shares.
A more preferable structure for you and the company would be non-cumulative dividends. These are paid on the preferred stock only if the board declares them; if they are not paid, they do not accrue and do not result in any future obligation to the preferred stockholders. Essentially that $5 million annual amount is forfeited as the next year begins.
Conversion rights add another layer of preference by offering the right to convert shares of preferred stock into shares of common stock in an exit event. This will be utilized when the common stock is more valuable than preferred.
A participating preferred stock is even more favorable for the investor, as we touched in the liquidation preference example. After the initial liquidation preferences are satisfied and the dividends are taken out (the “first dip”), the participating preferred shares allow the investors subsequent participation as a common shareholder along with the rest (the “second dip”). Participating will always give a higher return to the investor than convertible.
To continue the same case from earlier, an investor spends $50 million to buy 50% of your company with participating preferred shares at 1x liquidation preference. To you, this $50 million sounds like a lot and you’re happy. But let’s look at both upside and downside scenarios. In a perfect world, the value of your business doubles and you sell for $200 million down the road. The investor will get their $50 million first, and then participate in the remaining $150 million at their pro rata 50% ownership. They’ll walk away with $125 million and you will have $75 million. That’s not bad, but let’s look at a few more examples.
If their participating preferred shares had a cumulative dividend as well, they would get their $50 million first, and the $25 million from the dividend, and then their 50% pro rata ownership of the remaining $125 million. After the wires go through, they’ll have $137.5 million and you’re left with $62.5 million. So things got a little worse, but they’re still not that bad because the business sold for a nice multiple and was worth more today than years ago. Now consider the downside.
In a downside scenario where the business only sells for $75 million, the PE firm would get their $50 million out first, and then the remaining $25 million will be split among ownership, netting the investors an ultimate return of $62.5 million, while you and any other founders of the company are left with only $12.5 million. If we add the same cumulative dividend on top, the investors get $75 million and you walk away with empty pockets and not a boat in sight.
More common in VC deals than PE transactions, a redemption rights provision allows the holder of a preferred stock the right after a length of time to sell its shares for their original purchase price back to the company. Essentially it functions as a “put” right. These are exercised when the growth of the business has flat-lined or if the expected exit multiple has lowered considerably. It is another element of preferred shares that is extremely favorable to the investor compared to the original owner.
The single most important consideration when raising funds is anticipating how, as a company grows, new rounds of financing will affect the value of the shares of the company’s existing shareholders. To that end, dilution is frequently a very sensitive issue that requires careful and cautious decision making. As a company adds rounds of preferred capital for further investments, exercises management stock options, or issues additional options for existing or new employees, the number of shares an investor owns will increasingly represent a smaller percentage of ownership. Therefore, investors often seek to add anti-dilution provisions into the term sheet to afford them equal footing on a common equity basis, as determined by a conversion price that is usually fixed upon issuance of the stock. If the conversion price is able to fluctuate, it will greatly benefit the investor at the expense of the original shareholders.
Full-ratchet provisions are the most favorable treatment available for investors. In this case, the conversion price is adjusted to ensure that the new price factors in the total amount of capital invested and preserves the full percentage ownership of the preferred. This is particularly important in a down round – when the stock is devalued from its original price. Take a look at the below chart for a quick example of a full ratchet during a down round: the Preferred Series B shares were valued at $1 compared to Preferred Series A at $2, but the Series A shareholders maintained their ownership because of the adjusted conversion price.
Series A Price
|Common Shares Equivalent||Ownership %||Series B Price|
(& Series A Conversion Price)
|Common Shares Equivalent||Ownership %|
|Series A||$ 2||1,000||33%||$ 1||2,000||40%|
|Series B||0%||$ 1||1,000|
In this example, the options and common shareholders are diluted at the expense of the Series A investors, because of the anti-dilution provisions that were built into the term sheet. This type of protective covenant needs to be carefully negotiated from the company’s perspective.
As we mentioned above with the focus on dilution, a stock option pool is a key element to the term sheet that will play an increasingly important role in the company moving forward. Stock options are an excellent tool for incentivizing current management as well as recruiting key hires in the future. Therefore, a pre-determined option pool is usually designated in the negotiations for these purposes, which will inherently dilute the founders and investors from the start. The amount of reserved shares is typically 10-15% and it is critically important to discern whether this is considered as part of the pre or post-money valuation of the business. Additionally it is necessary to establish the proper vesting schedule, to avoid the unfortunate situation where an employee might cash in their stock and leave. Typically their options will vest in 1-3 years, sometimes with differing strike prices throughout the life of the investment.
The Term Sheet: Defined
So the term sheet is in your inbox and you are excited and intrigued. Not only are the numbers good, but you now understand them and can truly digest what the letter is offering to you and the business. Hopefully this brief article has armed you with some quick knowledge on what to expect behind the logic of the term sheet and will prep you for a better round of negotiations. As you and the investor both move forward, you should be able to reach common ground by now speaking the same language.
Mark Gaeto is a managing director with Falcon Capital Partners, a leading mergers and acquisitions firm, where he directs their commercial technology practice.
Conrad Olenik is an associate with Falcon Capital Partners and began his career with JPMorgan Chase.
Mark can be reached at 610-989-8903 or firstname.lastname@example.org.