Equity Financing and Entrepreneurs

Equity financing is a pivotal stage for startups seeking to scale operations and gain market traction. Understanding the terms that venture capital investor will request in connection with an equity investment, typically first encountered within a term sheet, is crucial for entrepreneurs to make informed decisions and protect their interests. The National Venture Capital Association (NVCA) model term sheet, or derivatives thereof, is a widely used template in the United States, guiding a substantial majority of priced equity financing rounds. This blog post will delve into five critical financial terms in these term sheets: pre-money valuation, dividends, liquidation preference, redemption rights, and payment of investor expenses.

Pre-Money Valuation

The pre-money valuation is arguably the most important financial term in your term sheet. It represents the value of your company before the investment and directly impacts how much of your company you’ll be selling in exchange for funding.

Typically, the pre-money valuation is a negotiated figure based on various factors, including:

Your company’s current financial performance
Growth potential
Market size and competition
Team experience and track record
Intellectual property and technological advantages

Certain strategic investors may have additional considerations which are not as clearly articulable as the foregoing, so founders should ensure they tailor the discussion to demonstrate the value of the company to that investor as well.

Additionally, investors will often seek to have the company increase the available shares under its stock plan and, occasionally, require that all convertible instruments (SAFEs and convertible notes) convert immediately prior to their investment, in each case diluting the founder group’s ownership of the company prior to the financing round. That is, the denominator for calculating the share price based upon the pre-money valuation will be larger, driving the share price down.

It’s crucial to understand that a higher pre-money valuation means you’ll give up less equity for the same investment amount. However, setting the valuation too high can lead to challenges in future funding rounds if you can’t meet growth expectations.

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Dividends

Another key area of negation relates to dividends, which generally represent a distribution of profits to shareholders. In the context of investor demands, dividend provisions can vary widely. The NVCA model term sheet offers several options:

No dividends
Non-cumulative dividends (investor receives dividends if and when they are declared by the company)
Cumulative dividends (investor has a right to accumulated dividends every year, whether declared or not).

Most early-stage startups opt for no dividends or non-cumulative dividends and investors will often agree, as cumulative dividends can have a material impact on the proceeds available to the founders and employees in the event of a company sale or IPO. As such, cumulative dividends are less common but may be seen in later-stage deals or in certain industries.

If dividends are included, they’re typically set at a fixed percentage of the original purchase price, often in the range of 6-8% annually. It’s important to note that even if dividends are provided for in the term sheet, they’re usually only paid out when declared by the board of directors.

As an entrepreneur, you should be cautious about agreeing to cumulative dividends, as they can significantly impact your company’s future cash flows and potential exit value.

Liquidation Preference

The liquidation preference is a critical term that determines how proceeds are distributed in the event of a company sale, including IPO, or liquidation. It’s designed to protect investors by ensuring they receive a minimum return on their investment before common shareholders (typically founders and employees) receive anything.

An entrepreneur can expect to see, and the NVCA model term sheet provides for several liquidation preference structures:

Non-participating preferred (simple preference)
Participating preferred (double dip)
Capped participating preferred

A simple one times (1x) non-participating preference is most common in early-stage deals. This means investors get their money back before other shareholders or, if the proceeds would be greater than that amount, investors would convert to common stock to share in proceeds with the other holders of common stock.

Participating preferred, while less common, allows investors to receive their initial investment back and then share in the remaining proceeds as if they had converted to common stock. This can significantly reduce the proceeds available to founders and other common shareholders.

While thinking past the immediate financing can be difficult, entrepreneurs should be wary of liquidation preferences above 1x or uncapped participation rights, as these can dramatically alter the economics of a potential exit.

Payment of Investor Expenses

The lead investor in an equity financing will often provide a term sheet which includes a provision for the company to pay the investors’ legal and due diligence expenses related to the financing. The NVCA model term sheet includes this provision, typically with a cap on the total amount.

Common points to negotiate include:

The cap on expenses (often between $25,000 and $50,000 for early-stage deals)
Whether expenses are payable regardless of whether the deal closes
Any limitations on the types of expenses covered

While paying investor expenses is standard practice, it’s reasonable to negotiate a cap that’s appropriate for the size of your deal and to ensure that payment is contingent on the deal closing. For instance, if company counsel is tasked with preparing the transaction documents based on agreed forms (again, typically those published by the NVCA), then the company would be justified in offering a lower amount where the review by investor counsel would be anticipated to be less involved.

Conclusion

Understanding these key financial terms in your term sheet is crucial for navigating venture capital investor negotiations successfully. Remember that while the NVCA model provides a standard framework, almost every term is negotiable to some extent.

As an entrepreneur, your goal should be to secure funding on terms that support your company’s growth while preserving your ability to benefit from that growth. This often involves finding a balance between investor protections and founder-friendly terms.

Always consider seeking advice from experienced legal counsel and financial advisors when reviewing and negotiating term sheets. Their expertise can be invaluable in understanding the long-term implications of these financial terms and in achieving the best possible outcome for your company.

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Dallas K. Mosier

What Entrepreneurs Should Expect in Equity Financing Term Sheets: Financial Terms