What to expect and where to push back
(This is part nine of a 9-part series on raising Seed capital in PropTech. For the rest of the series, check here.)
OK, fair warning. I’m going to be brief here.
There are literally entire books on term sheets and how to negotiate them. (Here’s something from Harvard.) I’m not doing that.
I just want to give you some high points and key takeaways from an investor’s perspective. Talk to your team, mentors, and attorneys before agreeing to anything in a term sheet.
Still, the thing you should know is: I care about two things more than anything else . . .
Everything else is (more or less) ancillary. That’s not to say registration of securities clauses are unimportant or should be ignored. But most VCs, you will find, can be pretty flexible around the terms in a term sheet OTHER THAN how much of your company they own and how that ownership can change (i.e. be controlled) in the future.
Here are some terms you will see:
At least $2,000,000 and up to $3,000,000 of which at least $1,000,000 and up to $2,000,000 will be invested by INVESTOR.
Price Per Share:
$0.25 per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).
The Original Purchase Price is based upon a fully-diluted post-money valuation of $10,000,000. This includes augmenting the Company’s existing employee option pool so that it represents 15.00% of the fully‑diluted post-money capitalization of the Company prior to Closing. Any outstanding notes or other securities that are to convert into this financing round will be deemed converted prior to the Closing and their conversion will not result in a change to the Post-Money Valuation.
A few things to note here —
- First, this hypothetical lead investor proposed a funding range within which they would be comfortable investing. What they did NOT give you a range on was valuation. In this scenario, the company is worth $10M whether you raise $2M or $3M. The value of the company doesn’t change, just the percentage of the company acquired by investors.
- Remember what I said about control above? This is a great example. The investor sets the valuation and then has control over how much they get of this round depending upon how well this founder and his team do in fundraising. In this case, the investor is aiming to have a post-money stake of between 10% and 20% of the company’s outstanding shares after this round is closed.
- Second, price per share is important because it’s a uniform metric you can track for (literally) the entire life of the company. Future rounds will be reflected in price per share. An IPO will be priced at price per share. A merger or acquisition will be priced per share. You get the point. This is a great metric and yet another reason why priced equity rounds are really the only type of financing you should be entertaining.
- Third, notice how the Valuation clause is contemplated as “post-money”. Remember how I said that nearly every investor, when they discuss valuation, talks in terms of pre-money? This is set in terms of post-money for the sake of clarity. If I were to paraphrase this in layman terms it would say:
“After all your outstanding investors are converted, future employees are accounted for, and all financing is completed, I will own 10–20% of your company. “
- Again, ownership and control. Under those stipulations there is no (legal) way this investor could be diluted out of that position. That’s precisely why they spell out the employee pool and past-investor-conversion. So no one is confused. “We will own 10–20% of your company.”
- Finally, it may surprise some first-timers that this investor only wants to take 50% of this round. You probably knew that each round has multiple investors, but you may not have know that this 50% is pretty common and a standard “exposure” practice for investors. Exposure, in this case, means that an investor doesn’t want the entirety of the round with any single party, including themselves. There are several reasons for that, but the one to think about from the VC perspective is diligence.
- Think about it — If you can’t raise an additional $1M from investors when I have already committed, in writing, the first $1M, then how good of a salesman are you, really? If you aren’t that good of a salesman, why should I be investing in a tech company that depends upon you selling tech to TONS of people? See what I mean? You still have some proving to do about your skills beyond a presentation and some diligence questions. I may help you and make some investor intros for you, but you still have to close them.
On to some final terms of note:
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:
First pay “X” (X is between 1 and 5 depending on several factors) times the Original Purchase Price plus declared but unpaid dividends on each share of the Company’s Series Seed Preferred Stock (the “Preferred Stock”) on a pari passu basis (or, if greater, the amount that the Preferred Stock would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.
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 a majority of the Preferred Stock 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 or earn-out in connection with a Deemed Liquidation Event.
- If you come from the CRE world, this of this like a pref (preferred return). The guys with the most money in get paid back first. Simple as that. It makes sense and it’s another control measure for the VC to feel comfortable you aren’t paying off your parents’ angel money before we get our cash out.
The Series Seed Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series Seed Preferred as a class shall be entitled to elect one (1) member of the Board (the “Series Seed Director”), (ii) as provided under “Protective Provisions” below or (iii) as required by law. The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.
- Hint — The Series Seed Director is probably me or my partner. Again, I get a vote and an active role in what happens to my shares of your company. CONTROL.
So long as any shares of Preferred Stock are outstanding, the Company will not, without the written consent of the holders of at least a majority of the Company’s Preferred Stock, either directly or by amendment, merger, consolidation, or otherwise:
(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws; (iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Preferred Stock, or increase the authorized number of shares of Preferred Stock; (iv) cause or permit any of its subsidiaries to, without approval of the Board of Directors, including the Series Seed Director, sell, issue, sponsor, create or distribute any digital tokens, cryptocurrency or other blockchain-based assets (collectively, “Tokens”), including through a pre-sale, initial coin offering, token distribution event or crowdfunding, or through the issuance of any instrument convertible into or exchangeable for Tokens; (v) purchase or redeem or pay any dividend on any capital stock prior to the Series Seed Preferred, other than as approved by the Board, including the approval of the Series Seed Director; (vi) create or authorize the creation of any debt security unless such debt security has received the prior approval of the Board of Directors, including the approval of the Series Seed Director; (vii) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets; or (viii) increase or decrease the size of the Board of Directors.
- All of that stuff might materially change my equity position and the value of the company. You can’t do any of it without an affirmative vote from me. CONTROL.
In the event that the Company issues additional securities at a purchase price less than the current Series Seed Preferred conversion price, such conversion price shall be adjusted in accordance with an industry standard, broad-based weighted average formula.
The following issuances shall not trigger anti-dilution adjustment:
(i) securities issuable upon conversion of any of the Series Seed Preferred, or as a dividend or distribution on the Series Seed Preferred; (ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security; (iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and (iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors including the Series Seed Director; (v) shares of Common Stock issued or issuable to banks, equipment lessors pursuant to a debt financing, equipment leasing or real property leasing transaction approved by the Board of Directors of the Corporation, including the Series Seed Director.
- If you have a “down” round, we’ll use a weighted-average formula to determine ownership. None of these debt-like conversions or issuances count. CONTROL.
Management and Information Rights:
A Management Rights letter from the Company, in a form reasonably acceptable to the Investors, will be delivered prior to Closing to each Investor that requests one.
Any Major Investor will be granted access to Company facilities and personnel during normal business hours and with reasonable advance notification. The Company will deliver to each Major Investor (i) audited annual financial statements within 90 days following year-end; (ii) unaudited quarterly financial statements within 45 days following quarter-end; (iii) an annual budget (at least 30 days in advance of implementation or effective date thereof) and other annual business plans, if any, showing monthly projected financials; and (iv) monthly updates and unaudited financial statements showing actual performance compared to budget and key performance indicators within 30 days of month end.
Right to Participate Pro Rata in Future Rounds:
All Major Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet and issuances in connection with acquisitions by the Company). In addition, should any Investor choose not to purchase its full pro rata share, the remaining Investors shall have the right to purchase the remaining pro rata shares. Pro rata rights will apply to an offering of digital assets as well.
- I can sum these two up in seventeen words — “I get performance data when I want it and I get my share of the next round”. CONTROL.
Matters Requiring Investor Director Approval:
The Company will not, without Board approval, which approval must include the affirmative vote of the Series Seed Director:
(i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of two years; (v) incur any aggregate indebtedness in excess of $50,000 that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person; (vii) hire, fire, or change the compensation of the executive officers, including approving any option grants; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; (ix) sell, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or (x) enter into any corporate strategic relationship involving the payment, contribution or assignment by the Company or to the Company of assets greater than $100,000.00.
- Don’t do any of these major things without my approval. CONTROL.
Key Person Insurance:
Company shall acquire life insurance on the Founders in an amount satisfactory to the Board. Proceeds shall be payable to the Company.
- We need money to hire a replacement CEO if you die. CONTROL.
Right of first Refusal/
Right of Co-Sale (Take-me-Along):
Company first and Major Investors second have a right of first refusal with respect to any shares of capital stock of the Company proposed to be transferred by Founders and present and future employees holding Company Common Stock (whether then held or subject to the exercise of options), with a right of oversubscription for Major Investors of shares unsubscribed by the other Major Investors. Company must exercise its right of first refusal within 15 days of receipt of notice from selling stockholder. Before any such person may sell Common Stock, including repurchases by the Company other than upon termination, s/he will give the Major Investors an opportunity to participate in such sale on a basis proportionate to the amount of securities held by the seller and those held by the participating Investors.
- You have the first right and I have the second right to buy stock from founders and employees so I/we can control outstanding stock. CONTROL.
Obviously, term sheets have more details and clauses in them than the few I have highlighted here. But these are the key ones I care about that can directly affect my ownership stake in your company and my control over what happens to that ownership in the future. If I can’t feel secure that I know exactly how much of your company I will own between now and your next financings and that I have measures in place to protect that stake, them I’m not interested in investing.
I said it at the beginning and I’ll say it again here — Talk to your team, mentors, and attorneys to truly understand what each clause in a term sheet means. Because if you don’t, and your company does well, I guarantee one of those will come back to haunt you. You’ve been warned!