Understanding Venture Financing Terms
October 12th, 2011 by administratorby Ju Park, Esq.
Despite a somewhat uncertain economic outlook, investment by venture capitalists for the year 2011 has remained steady. Although the stock market may not be performing as well as desired, investors continue to look for good opportunities with start-ups and other private companies. An infusion of cash can be just what a business needs for success, but term sheets from sophisticated investors often contain terms that can be confusing to entrepreneurs. This article explains some of the common provisions found on financing term sheets.
Common vs. Preferred Stock
Most corporations are formed with founders and employees receiving common stock. Venture investors, on the other hand, tend to demand preferred stock, which, as the name suggests, offers various preferences over common stock. Preferences can include dividend, conversion, voting, liquidation, and redemption rights. Preferred stock can be thought of as being “senior” to common stock in that preferred holders will generally get things first, or will have higher priority than common stock. Corporations can have multiple “series” of preferred stock (typically designated by a letter, such as Series A, Series B, and so on), with each series having different rights depending on the terms negotiated by the series investors. Just because a series of stock comes first in the alphabet doesn’t mean that it has priority over the other series, however. As companies grow and attract larger investments, subsequent investors may demand preferential treatment for their particular series of stock.
Liquidation Preference
A liquidation preference is a standard way that venture investors will protect their investment in your business. If the term sheet specifies that preferred stock will have a liquidation preference, it means that on a liquidation event (typically a sale of the company’s stock or substantially all of its assets, bankruptcy, or some other event whereby a company ceases to exist), the venture investor will recoup at least some of the money they’ve invested before the holders of common stock will see any money. If a series of preferred stock has a “senior” liquidation preference, it means that it will be entitled to receive its liquidation preference before other preferred series. Although liquidation preferences are commonly set at “1x,” which means that the investor will receive only the amount of their original investment, a “multiple” liquidation preference specifies that investors will receive more than the original investment (for example, a 3x liquidation preference means that the investor will receive three times their original investment).
Participation
A term that goes hand-in-hand with liquidation preference is whether the preferred stock gets to “participate” after receiving the liquidation preference. Commonly thought of as a “double dipping,” participation rights allow a preferred stock holder to share the proceeds of a company sale with the common stock holders. Participation works such that on the sale of a company, for example, the preferred stock will receive the full liquidation preference amount specified in the terms of their preferred stock, and will then share the remaining sales price pro rata with the common stock holders. Participation tends to be an investor-favorable term, especially with a favorable liquidation preference. These terms in conjunction can often mean that the preferred stock holders will receive a significant portion of the proceeds of any sale of the company. As with liquidation preferences, participation rights can be “capped,” which is usually expressed as a multiple.
Cumulative Dividends
Dividends are a distribution of a company’s earnings, typically from the company’s profits. Dividends are usually issued in the form of cash or stock, with most venture investment term sheets requesting “cumulative” dividends on the amount invested. Most venture term sheets specify a five to eight percent cumulative dividend on the purchase price of the preferred stock. Although it is rare for venture investors to require a company to make annual dividend payments of cash, they will often receive the cumulative dividends on a later sale of the company. If, for example, the venture investor provided a $1 million dollar investment with a 5% cumulative dividend and a 1x liquidation preference, and the company was sold 5 years later, that investor would receive $1 million dollars (1x liquidation preference) + $250,000 (5% dividend of $50,000 for 5 years) before the common stock holders received any money from the sale. Cumulative dividends tend to be uncommon in venture financings, and are often tied into liquidation preferences as a way for investors to require a minimum return on investment.
Antidilution Provisions
Antidilution provisions protect investors’ ownership stake in a company and are frequently designed to protect investors in the event that subsequent company financings occur at a valuation lower than their own. Preferred stock holders will usually have the right to convert their shares of preferred stock into common stock at a certain ratio (typically 1:1 to start). Antidilution mechanisms increase the conversion rate of preferred stock, so that the preferred stock holders will receive additional shares of common stock in order to protect their percentage ownership of the company. The two most common antidilution provisions are “weighted average” and “ratchet” antidilution.
A “weighted average” antidilution term is more favorable to company founders and increases the conversion rate of preferred stock based on a formula that takes into account the overall effect of the proposed issuance of new stock in the company. The formula factors in new price per share, old price per share, shares already outstanding, and shares to be issued. “Ratchet” antidilution, on the other hand, increases the conversion rate of preferred stock based on the new price per share regardless of the number of shares being sold. When the new price per share is lower than the old price per share, this method essentially reduces the price per share of preferred stock retroactively. “Ratchet” antidilution favors investors heavily, and has fallen out of favor as a typical method of antidilution protection.
Conclusion
When faced with investment opportunities, entrepreneurs will often want to go by the industry “standard,” particularly when they are presented with a term sheet containing unfamiliar provisions. There are a number of model documents that are promulgated by various groups that can help entrepreneurs assess a proposed investment. Entrepreneurs should be aware, however, that “standard” transactions may not the appropriate fit for their company, and that despite what venture investors might suggest, there can be a significant amount of room for negotiation. Entrepreneurs who are able to decipher the key provisions of a term sheet will be able to get a much better sense of the deal being offered, and will be able to negotiate on those provisions that are most important to them.