Understanding Term Sheets - Part 1: Liquidation Preferences

A practical guide to fundraising for early-stage startups with infographics and calculations Introduction The language of venture deals remains opaque and confusing to this day. This works to the advantage of industry insiders and to the disadvantage of those who are new to startups and venture capital. So for anyone interested in startups and venture capital financing - but especially founders who are planning to fundraise, I am writing this series to explain some of the most important provisions in a term sheet so that we know what these terms mean for our startups and which terms to negotiate. Let us start with liquidation preferences. What does it mean? It determines how the proceeds are shared in a liquidity event such as the sale of the company or its assets. Components : What multiple of the original investment is returned to the investor before the common stockholders? Preference : Once the preference is returned, what are the additional proceeds that investors receive? Participation How do preferences vary among different stages of financing? : Series B investors get compensated before Series A investors and so on. Stacked : All are equivalent in status and are returned preferences on a pro-rata basis. Blended (pari passu) How preferred shareholders maximize their payoff during a liquidity event? Preferred shareholders have the option to convert their stock to common stock per the conversion ratio or share the proceeds on an as-converted basis. : Payoff is the maximum of the preference and the corresponding value of the common stock. No participation : Payoff is the sum of the preference and the corresponding value of the common stock on an Full participation as-converted basis. : Cap is usually set as a certain multiple of the original investment amount. This cap is the upper limit of the payoff. Capped participation Let’s look at the payoff for investors and founders in the following scenarios. Scenarios: The startup has raised one round of financing. Acquisition price ≤ Total capital raised Common shareholders (founders, employees, etc.) do not get a penny since all the proceeds are to be returned to the preferred stockholders (investors). Avoid raising such high amount that a reasonable acquisition becomes out of the question. Acquisition price = 3–10 x Total capital raised (low acquisition price) Note that participation feature has a significant impact if the acquisition price is low. 3. Acquisition price = 20–30 x Total capital raised (high acquisition price) Note that participation feature has less impact if the acquisition price is high. 4. Acquisition price = 10-20 x Total capital raised (mid acquisition price) & more money is raised with a participation feature Note that participation feature has a significant impact if more money is raised with participation feature. 5. Multiple financing rounds & Acquisition price ≤ Total capital raised What are the benefits of liquidation preferences for investors? : a. Provides downside protection where investors can, at worst, get their investment back b. Ability to cash in on the upside as investors can convert to common stock Preference : Participation a. In addition to preference, the ability to share in the proceeds on an as-converted basis Closing Thoughts: In this post, we learned the following: What does liquidation preference mean? What are its main components and their benefits to investors? How do different shareholders get compensated in case of a liquidity event? How do investors maximize their payoff by negotiating for a specific participation type? How are the proceeds shared among preferred and common shareholders in different scenarios? The infographic below summarizes some of these key points. Calculations: If you are interested in understanding the math behind the above participation types, check out the spreadsheet . here References: Feld, Brad and Mendelson, Jason. . Wiley, 2019. Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist Acknowledgments: Cover Photo by Joanna Kosinska on Unsplash | Edited by author : Nothing in this article constitutes professional investment advice. Please do your own thorough research before making any investment decisions. Disclaimer

Understanding Term Sheets - Part 1: Liquidation Preferences

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