Investment in Startups: Main Impacts of Change in Investors’ Term Sheets
During the last few years, the trend of venture capital firms and other investors requesting liquidation preferences in term sheets has significantly changed. In the last three or four years, investors have switched from fully participating preferred shares in most previous deals, to non-participating preferred shares in a majority of deals.
In this article, we’ll see what this means, and assess the impact it has for startup founders and seed investors.
Two Periods, Two Different Approaches
The liquidation preferences and economic rights of preferred shares in term sheets can be summarized into two distinct periods.
Period 1 (up to 2010): Venture Capital firms and other investors asked to be issued fully participating preferred shares in the majority of term sheets. This means that at any liquidity event (M&A, liquidation of the company, etc.), these investors received first (prior to the common shareholders) – their original investment with or without interest (depending on the terms), plus an additional amount of cash based on their percentage of dilution in the company’s equity (if there was any additional cash to distribute). These terms had a negative impact on founders, because founders received less than expected in many cases.
Period 2 (from 2011 to present): The market has experienced a significant euphoria recently, and investors in startups understand that fully participating preferred shares strongly decreased founders’ motivation, causing a negative impact on their investment. Therefore, a new trend of preferred shares has started to take shape and expand from Silicon Valley to the rest the world: non-participating preferred shares.
So what does this mean? It means that at the exit (M&A event), investors receive the greater of their investment (either with or without interest), or they can decide to convert into common shares based on their percentage of dilution in the company’s equity.
When we look at recent market data, we can see that a large majority of preferred shares are non-participating preferred shares, representing 81% of term sheets in 2015 (source: “The Entrepreneurs Report, 2015”, Wilson Sonsini Goodrich & Rosati):
Let’s look at an example. Prior to the Series B round, this particular company raised $3 million through a Series A round, based on a $15 million post money valuation ($3 million/20%). In addition, the investor and the company agreed to issue an unallocated Employee Stock Ownership Plan (ESOP), with an exercise price of $10 per share, representing 10% of the company’s equity on a fully diluted basis. The table below describes the post Series A cap table of the company:
Step 1: Suppose that the company is currently raising $4 million in a Series B round from new investors. In this example, we assume that they’ve agreed on an 8% stake in exchange for $4 million invested in the company. A term sheet is being negotiated.
Step 2: The new cap table is created based on the following: $4 million divided by an 8% equity stake in the company on a fully diluted basis, resulting in a post-money valuation of $50 million ($4 million/8%). This reflects the ownership structure, but does not consider actual economic returns.
What then will be the round B financing – post money cap table of the company?
The problem here is that this overly simplistic presentation of the cap table and dilution calculation assumes that all share classes have the same economic rights. It ignores the economic impact of the liquidation preferences, as well as the different economic rights of preferred shares, common stock, and stock options.
What then is the true amount of cash received by each share class or shareholder, if there is a liquidity event based on a company value of $100 million?
Scenario 1: The series B and A preferred shares are non-participating.
In this example, Series B will first receive the original investment at a company value of $4 million, and will convert into common shares at a company value of $47.12 million. Series A will then receive the original investment at a company value of $7 million, and will convert into common shares at a company value of $17.5 million. Below are tables representing an allocation of the company value and waterfall graphs generated from AlgoValue, illustrating the true economic value of these shares, respectively (please note that the percentage of dilution is slightly different from the cap table, due to the fact that stock options holders will exercise their stock options at a company value of $29.71 million).
Scenario 2: The series B and A preferred shares are fully participating.
In this example, Series B will first receive the original investment at a company value of $4 million. Series A will then receive the original investment at a company value of $7 million. From a company value of $7 million up to $35.201 million, Series A and Series B will receive cash on a pro-rata basis with common shares. From $35.201 million and above, Series B and Series A will receive cash on a pro-rata basis with both common shares and stock options. Below are tables representing an allocation of the company value and waterfall graphs generated from AlgoValue, illustrating the true economic value of these shares, respectively.
Scenario 2 vs. Scenario 1: Together, the founders have lost $4.5 million at a liquidity event of $100 million.
Outlook for 2016
By the end of 2015, startup valuation has been decreasing in the U.S., and this trend has been expanding overseas as well. As a result, investors are expected to require different term sheets for startups’ founders, and specifically require more term sheets with capped participating preferred shares (investors receive the greater of a multiple of two times or more on their original investment, or they can decide to convert into common shares based on their percentage of dilution in the company’s equity). In addition, startups are expected to face more down rounds if not able to prove significant achievements from their last round of financing.
This is where AlgoValue can help. AlgoValue helps startups and investors maximize their negotiations, and become better prepared to handle the challenges that come with capital raising today.