Investing in a startup: term sheet

In the near future I will start investing in startups. This is a description of how I’ll structure the investment process:

  • List: define a list of startup operating in areas of interest
  • Decide: select some startups using an investment strategy
  • Close: pay the founder for a percentage of the company signing a contract

I would like to focus on the last point of the list: the contract. To formalize the agreement with the founder I’ll need a layer to write a contract, or I can go on the seedsummit legal docs webpage and download their Seedsummit Angel Investments Term Sheet V1.

Let’s analyse some of the terminology of the document:

Structure of Financing – The financing will be up to an aggregate of [___] at a fully diluted pre-money valuation of [___], including an unallocated employee share option plan (“ESOP”) of [     ]%.  The Lead Investor will invest up to [___] and would hold no less than [___]% of the Company on a fully diluted basis.

  • The financing will be up to an aggregate of [_€1000__] at a fully diluted pre-money valuation of [_€9000__]: we are defining the pre-money valuation of the company and the amount I’ll invest. The pre-money concept is explained in the following points. With €1000 I will receive a number of stocks, that often are preferred stocks (not in this case). Fully diluted basis means that if I buy a X% of the company,  in the ratio, the denominator is the total number of shares issued by the company on the assumption that all options and stocks are exercised.
  • Including an unallocated employee share option plan (“ESOP”) of [  30  ]%:the shares structure of the company will have 30% of options on common stock. Founder wants options to attract early employees. The advantage of the option against the share is that you will pay taxes when you will exercise them. 3 things are important in options: 1) strike price low, 2) holding period long, 3) vesting period. If a company is not early in its development, the “fair market value” regulations can push high strike value. Most stock options in startups have a long holding period: 5-10 years. Vesting usually happens over a 4 years term. Many companies “cliff vest” the first year meaning you don’t vest into any shares until your first anniversary. Note that when a sale event happens, only vested options will become liquid. More information from Fred Wilson and Venture Hacks blog:
  • The Lead Investor will invest up to [_€1000_] and would hold no less than [_10__]% of the Company on a fully diluted basis: I’m buying 10% of the company with €1000. I’m valuing the company post money at 10%*X=1000, or X=€1000/10%=€10000. The pre-money value is: post money-(new investment)=€10000-€1000=€9000. An important consideration related to pre-money valuation is the fact that with €1000 I’m not buying common shares like the founder shares. This are normally preferred stocks, and  the €10000 refers to common stocks, so the €9000 valuation is close to meaningless (not in this term sheet).

Type of Security – Ordinary Shares [to be issued in two series if EIS qualification is sought]: in this document the shares are common. If we look the other document from Sedsummit webage: Seedsummit General Investments Term Sheet V1, the type of security are preferred shares. The EIS (Enterprise Investment Scheme), that recently has been revised and called BASIS (“Business Angel Seed Investment Scheme”), permit to UK investor to have tax advantages when investing in tech companies. More info in this article from Techcrunch.

[Priority Payment on Exit] – (….) The Lead Investor shall be entitled to receive the higher of: (i) The financing of € (being the original purchase price paid by the Lead Investor) plus any declared but unpaid dividends; or   (ii) The Lead Investor’s pro rata share (based on its ownership of the shares) of such assets or proceeds: if there is an exit an early investor can receive the intial money + dividends, or the value of the proportion of the shares he owns. This is a protection against down rounds (rounds that will value the company less than the previous valuation) and often is called liquidation preference.

Pre-emption – All shareholders will have a pro rata right, but not an obligation (…): when there are new rounds of financing the early investor has the right to buy more stocks to maintain the same percentage of ownership. As Fred Wilson is stating in this post, this is one of the 3 most important terms that really mattered in a venture deal. He calls this term, right to participate pro-rata in future rounds, the other 2 terms are liquidation preference, and right to a board seat.

Right of First Refusal and Co-Sale – The Investors shall have a pro rata right, but not an obligation: if early investor doesn’t want to invest in the company, he can get the cash and give his stocks to other investors

Drag Along – In the event that the holders of a majority of the Ordinary Shares wish to accept an offer to sell (…) then subject to the approval of the Lead Investor and the Board, all other shareholders shall be required to sell their shares or to consent to the transaction on the same terms and conditions[, subject to the liquidation preference of the Lead Investor]: is a term that limit the deal decision process to be influenced by the board and lead investor. The liquidation preference for the lead investor is a protection for down rounds. Some investor tries to set liquidation preference in excess of 1x. To understand this concept let’s consider a company owned 50% from the founder and 50% by the VC. If the company is sold for the amount the VC has invested he will receive everything. If the liquidation preference is set at 2x, the VC will take everything  even if the company is sold at 2x VC investments. In this case the term should be negotiated.

Founder Shares – Shares held by the Founders will be subject to reverse vesting provisions over three years as follows: [25% to vest one year after Closing and the remaining 75% to vest in equal monthly installments over the next following two years]. If a Founder leaves the Company voluntarily or is dismissed for cause, they shall offer for sale to the Company (with a secondary purchase option for the holders of Seed Shares) any unvested shares at the lower of nominal value or subscription price. [There shall be acceleration upon double trigger provisions so that if a Founder leaves after a Change of Control, unvested shares may become vested.]

  • Shares held by the Founders will be subject to reverse vesting provisions over three years as follows: [25% to vest one year after Closing and the remaining 75% to vest in equal monthly installments over the next following two years]:  under this arrangement, the founder is asked to give up ownership rights to his stocks, and then earn them back overtime: 25% afer1 year, and 75% after 3 years. Following a link to calculate the effect of vesting:
  • If a Founder leaves the Company voluntarily or is dismissed for cause, they shall offer for sale to the Company (with a secondary purchase option for the holders of Seed Shares) any unvested shares at the lower of nominal value or subscription price. [There shall be acceleration upon double trigger provisions so that if a Founder leaves after a Change of Control, unvested shares may become vested.]: the double trigger set the 2 conditions that trigger the acceleration of the unvested shares. Often this conditions are: 1) an exit event, 2) the firing of the founder. More on this argument at the following link:

The last important information is the term sheet is the capitalization table. As explained in this post from Fred Wilson, a cap table is a spreadsheets that show how much everyone owns of the company. There are different templates available on the web explaining the evolution of the stock ownerships during the journey of the company through different financing rounds:

This was a long post… as Pascal said: “I have made this letter longer than usual, only because I have not had the time to make it shorter”!

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