We wrap up 1st round play in Boston! Term Sheet central here!
1. Liquidation Preference vs. 4. Employee Option Pool
Liquidation Preference*: The determining term on how the proceeds of an exit will be shared. The preference is given to preferred shareholders before common stock holders and can have vast implications for investors/entrepreneurs. Three types with very basic examples below:
- Fully Participating: Receive shares on an “As-converted” basis i.e. if you have 2x Liquidation preference on 20% stake in a $100M post-money valuation (i.e.a $20M investment). If the firm sells for $240M you will receive $40M (2x preference) and then 20% of remaining $200M or $40M for a total of $80M or 33% Ownership. Founders receive remaining $160M. C:V. Thought: Yikes.
- Capped Participation: Will only participate up until a limit (i.e. 2x cap). In this case, the firm makes more than double their money so they will not participate and simply receive 20% of $240M or $48M. Founders receive remaining $192M. C:V. Thought: Less Yikes.
- Non-Participating: Firm sells for $240M, investors receive 20% or $48M. Founders receive remaining $192M. C:V. Thought: Normal.
*Editor’s Note: we combine participation and preference in this term
Employee Option Pool: The amount of equity to be held for future issuance to employees. This can be a sneaky way to lower a company’s pre-money valuation if one is not too careful (larger option pool than prior cap table). This is also a key term as it will help determine the resources a founder will have when allocating and attempting to attract new talent to the company.
C:V.’s Chief Term-ologist’s Take: While Options are key retention measures for future employees, poorly structured liquidation preferences can have devastating ramifications for “less than spectacular” exits on founder/employee ownership. You can work to redeploy your options at later rounds, but attempting to get rid of a fully participating 3x liquidation preference is an evil nobody EVER wants to deal with.
Outcome: Liquidation preference fends off an inspired comeback in the 2nd half from Option Pool to advance.
2. Antidilution vs. 3. Conversion Rights
Antidilution: A protective measure in the unfortunate case of a down round, it offers investment protection for investors by redefining the ownership of their initial investment. Two types below:
- Full Ratchet: The harshest of the provisions, this translates the equity ownership from the prior round to the new price at the lower round. i.e. If the original round was 20% on $100M Post (i.e. $20M investment) and the new round only valued the company at $50M the investors would then be awarded shares to keep their ownership the same at $20M or 40% of the new company. (See, we weren’t kidding that this was basically draconian…)
- Weighted Average: A more forgiving provision that puts the incentive on both sides of the table. The weighted average model only considers the new shares being issued and not the entire pool.
Conversion Rights: The ability to convert preferred equity into common stock. Automatic conversion gets
infuriating interesting when investors “must” convert at different prices upon an IPO. If one investor has a $20M auto-conversion and a later round investor has a $60M conversion and the company wants to price an IPO at $50M then the later round investor can stall until the company can float an offering that will reach their $60M auto-conversion price.
C:V.’s Chief Term-ologist’s Take: While Conversion can get interesting upon an IPO, antidilution provisions can effectively cram-down any remaining founder ownership. You tell us an original founder that is truly motivated to succeed after having half of his/her share taken at the B round and we will tell you about our cousin from Nigeria….
Outcome: In a less than eventful 2 v 3 matchup, Antidilution blows out Conversion to advance.