The aim of this piece is to demystify the termsheet: to explain the jargon to watch out for and give you practical examples and resources to understand what each term might mean for your business.
So far in the series, we’ve looked at the economic terms of the investment - first the valuation, and then the liquidation preference and waterfall. If you have a handle on those two areas then you can understand the value of an investor’s cash on its way in, and what it will be worth on its way out - clearly that’s key.
You can’t stop there, though. The vast majority of a termsheet isn’t about the economics - it’s about the way the company will operate while it has the investor’s cash in and the tools your investor can use to protect the stake that they have taken in the company. The next few articles in the series will deal with those protections, beginning in this article with protections around issuing new shares.
“Pro rata” (adjective) - “in proportion to”. Usually, refers to dividing something up among shareholders in the same proportions as their shareholdings in the company
“Pro rata” (noun) - almost always refers to a shareholder’s proportion of a new share issuance
“Down round” - an investment round conducted at a lower valuation than previous
The Portfolio View
We’ve been using the example of $5 million invested at a $20 million pre-money valuation, which leaves your investor holding 20% of your share capital. Clearly, this has the most significance for you as the founder, and the company that you’ve created, but it’s not insignificant for the investor.
Investors have a limited number of investments that they can make; some will be winners, some will break more or less even, and some will fail. An investor will have a strategy to generate a return on that portfolio of results. One key part of that strategy will be the percentage of the company that they own by the time of a Liquidity Event or “exit.”
Backing The Winners
Let’s consider the positive scenario first. The company does well, and later you look to raise $15 million on a pre-money valuation of $60 million. The company, and therefore the investor’s stake in it, is worth far more than when he invested and looks to be on the path to a big exit. As part of his overall portfolio strategy, your investor probably wants to get as much money into it as possible.
Your termsheet will likely say that when you issue further shares you have to offer your investor his pro rata amount, before you can offer them to anyone else. That might be described as a pre-emption right on issuance, or fall under a heading like “Follow-on,” “Further issues”, or simply “Pro Rata.” In our scenario, you would have to give your investor the opportunity to put in another $3 million (i.e. 20% of the total round), so that he can keep himself at 20% of your company.
Fast forward to a $200 million exit: your investor would take home $40 million - a profit of $32 million on his $8 million total invested. If he doesn’t invest in the second round, although his number of shares remains the same, his ownership percentage falls (he is “diluted”) and therefore so does his share of the exit proceeds.
In this scenario, the dilution from 20% to 16% leaves your investor crying himself to sleep at night on a pile of just $32 million after the $200 million exit, for a profit of a mere $27 million. For simplicity, in all our sale calculations we assumed that the investor has a 1x Non-Participating Liquidation Preference - so it would have converted.
(A 1x Non-Par what? This article is the third in a series - that term is explained in Part 2, and while you’re at it -- you might as well read Part 1...). Familiarize yourself with all of these parts concerning your termsheet, and you can become a real asset to your company.
That’s not to say that your investor will always take up their pro rata. They might not share the market’s view of your valuation or might not have the cash available at the time. Some investors, though a minority, will only invest in first rounds and never follow on.
It’s also worth noting that not taking up the pro rata produces a better “rate of return” because the investor puts less in - if he doesn’t follow on, he ends up with 6.4x the amount invested, instead of 5x. Where someone needs to show results on a per-investment rate of return basis, that might also be a reason for them not to put in the extra capital.
Usually, however, an investor is looking at total money in -- versus total money out -- across the entire portfolio,
Following up on the winners is the “normal” strategy because it should produce the highest total of money out. For that reason, the pro rata is generally a standard term and is almost always presented in termsheets...even by investors who have no intention of using it.
Variations On A Theme
Sometimes a termsheet will give the investor the right to “overapply,” i.e. exercise a right to take up more than their pro rata share of the new issue. This can be referred to as a “super pro rata,” and is more commonly seen where all shareholders (not just the investor) have the option - though of course, the investor is usually the one with the financial resources to exercise it.
For simplicity’s sake, in these articles, we are always working on the basis of a single investor. Where you have a group of investors, though, you might see a right for a majority or supermajority of them to waive the pro rata right on behalf of all of them - that can be very helpful, for reasons we’ll explore below.
The phrase “pay to play” gets used in a number of different ways, but often means that an investor who doesn’t take up their pro rata loses some rights - anything from losing the benefit of the ratchet on a down round to losing all of their investor-specific rights in the company from that point on. Not surprisingly, it’s rare to see a term like this in an investor’s draft of a termsheet; a founder might ask for something along these lines where the investor has the benefit of strong pro rata and anti-dilution protections.
Down Rounds And Ratchets
What about if the company goes the other way, and conducts a down round? Let’s assume here a $2 million emergency raise on a pre-money valuation of $13 million. If the original investor were to take up his pro rata he could maintain his 20%, but that would be worth just $3 million, compared to the $5.4 million total investment. On its own, the pro rata right protects your investor against dilution of his stake, but offers nothing against dilution of his value. For that reason, your investment termsheet might contain an anti-dilution protection, or “ratchet.”
The concept of a ratchet is that, as your company’s valuation has fallen, to preserve your investor’s value his ownership percentage must increase. Usually, that involves giving the investor extra shares or, where the investor’s existing shares are convertible, increasing the rate at which they convert into ordinary or common shares. Either way, the calculation of the extra shares is key as this has the potential to be extremely dilutive to the founders.
The most investor-friendly calculation is the “full ratchet.” This gives the investor extra shares as though their whole investment had been made at the same price as the down round. The alternative is a “weighted average” calculation, which factors in the size of the down round relative to the company’s total share capital and will produce a per-share price somewhere between the down-round price and the price the original investor paid. The weighted average can be “broad-based,” which means that shares under options, warrants, convertibles etc. are factored into the share capital calculation, or “narrow-based” if they’re not.
In our scenario, the down-round is relatively small, so our weighted average calculations skew heavily towards the founder-friendlier end of the scale. The difference between a broad and a narrow-based average is small - only taking account of the 6% ESOP.
Note: It’s the Founders and the ESOP who suffer the dilution, but even so this is far from a perfect protection for the investor. Despite a full ratchet, the devaluation of the company still means they've lost about 15%. On the weighted average calculations they are down around 45%, as opposed to 48% with no protection. These protections cushion the blow but don’t avoid it completely.
The other issue with these rights is the tension they can create with your new investor. In the first table, for example, we assumed that if the original investor decided to take up his pro rata then the new investor would just accept that they get 16% instead of 20%. With a super pro rata right the original investor could take any amount of the new round, and effectively dictate the size of the new investor’s stake.
An investor's portfolio strategy will require a big enough stake that an exit is a meaningful contribution to their total cash out, so this might be a problem -- particularly where you have multiple new investors splitting the deal. The founders might be able to accept some more dilution in order to get the new investor to the size of stake they need, but your new investor will need to feel that the team has enough equity to be properly incentivised to go all the way to a big exit, so this can only go so far.
That, Of Course, Is A Bigger Problem When Your Original Investor Has A Ratchet.
On the full ratchet anti-dilute we looked at, the founder team was down to 54% after two rounds. Assuming it would take a couple more rounds to get to an exit, and depending how many people are in the founder team, that might already be past the point where an investor would consider the team to be incentivised for the long run.
We mentioned above the possibility of a waiver provision, where your “original investor” is actually a group, such that a lead investor or two can drop the pro rata right or ratchet on behalf of all of them. This allows your next round to be a compromise between the priorities of your new investor and your original lead, rather than accommodating the priorities of every original investor. Your new investor will also have far less patience with a delay by someone who only took a small slice of the original round but is now insisting on their rights.
This isn’t meant to be an exhaustive guide -- we haven’t touched, for example, on technical issues like making sure option schemes are outside of the pro rata and don’t trigger the ratchet. The intention of this series is to highlight the big commercial issues, and the key point for you as a founder with these rights is understanding that they will dictate how your cap table develops over time, and will give your original investor significant leverage when you do your next round.
What you give away in your termsheet today is what you have to live with, and should dictate your approach to future transactions - learning your way around these provisions now will equip you to manage that process.