Author Archives: Nick DeLong

Venture Finance Terms: What is Reverse Vesting?

Fighting Over DollarIf your startup company is seeking venture capital funding, one major factor to consider is the impact the financing will have on the value of equity held by founders and management. Many VC term sheets include a provision requiring reverse vesting. In this post, I’ll explain what this means and the impact it can have on your equity stake.

Founders and management of startup companies typically receive their shares / options on a vesting schedule. This mean that instead of receiving all of their shares at onces, they are given the option to purchase shares a little at a time. For example, a founder with 16,000 shares might receive them on quarterly intervals over four years, meaning he gets 1,000 shares each quarter. After 4 years, he is fully vested, meaning he has received all of his shares or options.

Now suppose that the above founder, after he is already fully vested, decides to seek VC funding. The investors may include a term requiring reverse vesting, meaning the founder must relinquish his shares and then re-earn them on a new vesting schedule.

At first, such clauses may seem extremely unfair to founders and management. Sometimes these clauses do indeed cause problems, but a lot depends on the specifics. Generally, the purpose of reverse vesting is to prevent founders at newly funded startups from leaving the company with their shares. This helps VCs protect their investment, but it also helps the co-founders and the company in general. The loss of a founder or other key person can often doom a company, leaving the investors and other company founders in the lurch.

On the other hand, fairly written reverse vesting terms should have some indication of the conditions under which a founder can or can’t leave with his shares. Such conditions are known as “good-leaver” clauses. Generally under such clauses, if a founder leaves on his own or is fired with cause, he loses some or all of his non-vested shares. If he is asked to leave without cause, he keeps his shares. Without such clauses, the founder can be fired at will, and the other shareholders (VCs and other management) will reclaim his shares.

In summary, reverse vesting may seem unfair to founders or management, but if structured fairly such terms can benefit both investors and the company itself. As with every term in a VC deal, the devil is in the details.

Venture Fundraising Strategy: Planning for the Exit

exitIf you’re an entrepreneur planning to raise venture capital funding, you’re probably focused on the fundraising process itself, and rightly so. It’s often difficult to get the funding you need at the terms you’re looking for. However, even before you raise any funding, you should also be giving serious thought to your exit strategy.

VCs never make an investment without considering the exit – in other words, how, what and when they will get paid for the equity they own. This generally occurrs when the company is acquired through an M&A deal or goes public in an IPO. Entrepreneurs seeking VC funding should also think about the potential value of the company, and the founders and management equity stakes, in a variety of reasonable exit scenarios. In particular, you must consider how a proposed term sheet will impact your equity value given a reasonable exit scenario.

For example, consider the effect of dividends. In a recent post, we discussed the effect dividends can have on the upside for VCs and entrepreneurs. Specifically, in a downside situation (an unfavorable exit), dividends strongly favor VCs, particularly if the exit is delayed. Depending on the timing and terms, the effect is often significant.

Similarly, other VC terms such as liquidation preference and participation may have a huge imact on the amount recovered by entrepreneurs at exit, or no impact at all depending on the nature of the exit. If the company goes public, these terms do not affect the value of the equity owned, while in an M&A deal they are vitally important.

In summary, even before raising VC funding, you should consider the effect that your planned exit strategy has on the value of

 

Venture Capital Terms: Dividends

Dividends: Time is moneyWhen negotiating a VC term sheet, dividends are often not the main focus. This is because compared to other terms like liquidation preference and valuation, they do not always have as large an impact on the payout to VCs and company management. However, dividends should not be overlooked, as they have the potential to have a significant impact under the right circumstances.

Dividends are often considered a downside protection for VCs. In other words, if the company does well and has a large and favorable exit, the dividends do not have a large impact on the payout to the VCs or management. In contrast, if the company underperforms and has a less-than-hoped-for exit, the negotiated dividends are often a significant factor in determining the payout.

For example, consider the simple case of a company with a single VC investor. The VC purchases 50% of the company for a $10M investment. Although the company initially projected a $50M exit, after 5 years things are not going well and they decide to sell for $20M. If the deal includes no dividends, the VC will be entitled to $10M of the proceeds (assuming a 1X liquidation preference -see our post on this topic), and the management will get the other $10M.

Now consider the above scenario with the addition of a somewhat typical 10% dividend. In this case, the VC would be entitled to 10% of its investment, or $1M, for each year that has passed. Since it’s been 5 years, the VC gets a total of $15M of the $20M sale ($10M for the liquidation prefence and $5M for the dividends), while the management are left with only $5M.

Things can get further complicated when you consider the issue of compounding. Some dividends come with a compound rate, further increasing the amount owed to the VC upon exit. Some dividends are also payable in stock instead of cash, meaning the VC will own a larger percentage of the company the longer the exit is delayed.

So although dividends may not have a huge impact on the proceeds of a successful exit, they can have a large impact on payouts when the company exits for less than expected, or if the exit is significantly delayed.

Venture Capital Terms: Warrant Coverage

Warrant CoverageLast week I posted a short description of some common terms that are used to describe a company’s valuation on a venture capital term sheet. While everyone who negotiates a term sheet is likely aware of the importance of valuation during the negotiation, many other terms have a large impact on the deal and yet are often overlooked by entrepreneurs raising capital.

When a term sheet includes warrants issued to investors, the equity held by entrepreneurs and other common stockholders at the company will be further diluted. Therefore, the effect of warrant coverage should be carefully considered while negotiating the terms of a venture financing.

What is warrant coverage?

Warrants are additional shares that are issued to VCs on top of the shares they purchase with their invested dollars. The issued warrants typically carry the same terms and privileges as the purchased shares (e.g. liquidation preference). The warrants that are issued as part of a financing can be expressed as a flat share count, but they are often expressed as a percentage of the purchased shares, called warrant coverage. For example, if a VC invests $1M in a company at $1 / share, they will purchase 1M shares. If the terms of the financing include 30% warrant coverage, the VC will also receive an additional 300,000 shares in the form of warrants.

The effect of warrant coverage

As described in my last post, valuation is, and should be, a main focus of any term sheet negotiation. Even if a company is able to negotiate a favorable valuation, the benefit can be largely offset by other terms. Warrant coverage is no exception to this rule. For example, suppose a VC initially proposes a $5M pre-money valuation. The company pushes back, and eventually manages to get the investors to accept a $6M pre-money. This means that if the VCs invest $5M, they will own only about 45% of the company, rather than the 50% they would own at the originally proposed pre-money.

However, even with the $6M pre-money, if the term sheet includes 20% warrant coverage, then the VCs will effectively receive 20% more shares than were actually purchased with their investment. Thus, even though they invest only $5M, they will receive $6M worth of shares. Including the issued warrants, the VCs will own 50% of the company, effectively negating the benefit from the negotiated $6M valuation.

Summary:

  • Warrants are shares that are issued on top of those purchased by VCs during a venture financing.
  • Warrant coverage can offset the effect of a negotiated valuation.

Venture Capital Terms: Valuation

Purchase priceA company’s valuation at the time it receives venture capital financing is probably the most important factor influencing the outcome of a deal. Although some semi-quantitative methods for valuing a startup company are used, the valuation is largely a product of negotiation between the company and the investors. If a VC can negotiate a smaller valuation on a term sheet, it means they can purchase a larger percentage of the company for their investment.

Although multiple terms exist for discussing a company’s valuation, they are all derivable from one another, and are thus really just different ways of expressing the same underlying valuation.

 

 

  • Price per share: The price per share is perhaps the most familiar valuation term to those used to dealing with public companies. As in the stock market, the share price is the price paid by the VC for each share purchased. Thus, the number of shares purchased by a VC can be computed as the amount of the investment divided by the price per share.
  • Pre-money valuation: The pre-money valuation is defined as the value of the company prior to the financing. It can be computed as the price per share multiplied by the number of shares outstanding before the current round of financing.
  • Post-money valuation: The post-money valuation is defined as the value of the company after the current round of financing. It is calculated as the pre-money valuation plus the amount invested in the current round.

 

How the terms are related

It should be clear from the above definitions that these three valuation terms are very closely related, and have a very important impact on the deal’s outcome for the VCs as well as the common shareholders. For example, suppose a company has 1M shares outstanding and is raising a series A. Let’s further suppose that the VCs are investing $4M.

At a negotiated share price of $1, the investors will purchase 4M shares. This means that the investors will own 80% of the company (4M out of the total outstanding 5M shares). It also means that the implied pre-money valuation of the company is $1M (1M shares outstanding before the financing times the $1 share valuation). The post-money valuation in this case would be $5M: the $1M pre-money valuation plus the $4M investment.

Now suppose that instead of the above $1M pre-money valuation, the company successfully negotiates a $2M pre-money. This means that the price per share is $2 (1M outstanding shares before the financing, valued at $2M). It also means that the $4M VC investment will only buy 2M shares, or roughly 66.7% of the company.

 

Summary

  • The negotiated valuation on a VC term sheet has a huge impact on the deal value for the investors and the common stockholders.
  • There are multiple ways of expressing valuation (pre-money, share price, post-money), but they all express the same underlying company value.

Venture Capital Terms: Common Types of Anti-Dilution Provisions

Calculating Anti-Dilution ProtectionLast week, I posted a general discussion of anti-dilution protection, and how it’s included by VCs in term sheets to help mitigate the dilutive effects of a down round. As we saw last week, while such provisions help protect a VC’s investment when a company’s valuation drops, they provide no protection for common stockholders such as founders and company management. In fact, when VCs exercise such provisions, it actually magnifies the dilution experienced by the common.

This week, I wanted to expand this discussion by describing some common types of anti-dilution protection and what they mean. In last week’s post, I said that the mechanism by which anti-dilution provisions protect VCs is by altering the price at which their original investment converts to shares, thus allowing them to purchase shares at a price lower than the originally negotiated share valuation. The new conversion price depends on the type of anti-dilution provision that was in the original term sheet.

 

Full Ratchet

Full Ratchet is the form of anti-dilution protection that most strongly favors VCs. In this type of provision, the conversion price is set to be equal to the share valuation at the current down round. For example, if a venture firm called XYZ Ventures initially invests $2M at a share price of $2 per share in a Series A, the firm expects to own 1M shares in the company at the original purchase price. Now imagine the company fails to perform as expected, and when it raises the Series B, it receives a share valuation of only $1 per share. If the Series A term sheet included full ratchet anti-dilution, then the conversion price for the Series A investment is reset to the new valuation of $1. This means that XYZ venture’s initial $2M investment will actually buy them 2M shares instead of the original 1M.

Since full ratchet protection allows previous rounds to be re-priced at the same price as any future down rounds, it effectively prevents any dilution to the protected VCs. It is essentially a “low price guarantee” for VC firms, since it allows their original investment to purchase shares at the lowest price offered at any point in the future. Conversely, it is the least favorable provision to common shareholders, since it leads to the greatest number shares outstanding, and therefore the greatest degree of dilution of the common.

 

Weighted Average

Weighted average anti-dilution is less extreme than full ratchet, in that it reduces the conversion price of previous rounds, but does not set the conversion price equal to the price of the current down round. Thus it reduces the dilution experienced by protected investors in previous rounds, but does not eliminate the dilutive effect of a down round. The idea behind the weighted average is that the reduction in conversion price is computed as a function of the percent of the total shares outstanding that are owned by each investor. In this way, investors that own a larger percentage of the company receive greater protection from weighted average of provisions.

There are two sub-types of weighted average protection. Broad based weighted average calculates the total shares outstanding by including all preferred stock, common stock, as well as unexercised securities such as employee stock options. Narrow based weighted average includes only those shares which are currently outstanding, and excludes unexercised options. Thus, the narrow-based calculation is a little more favorable to VCs since it assumes a larger percent ownership, and thus a larger adjustment of the conversion price, for each investor.

 

Summary

  • Anti-dilution protection protects VCs by re-pricing their original purchase of shares at a down round.
  • Full ratchet protection effectively eliminates dilution of protected VCs at a down round by setting their conversion price to the share price of the down round.
  • Weighted average protection is less favorable to VCs than full ratchet, since it reduces the conversion price, but does not set it equal to the current valuation.
  • Anti-dilution provisions are most favorable to VCs lead to the greatest dilution of common stockholders if a down round occurs.

Venture Capital Terms: Anti Dilution Protection

Anti-dilution: planning for a rainy dayNegotiating a venture capital financing is often difficult for those not familiar with the meaning of some common VC deal terms. Share price and liquidation preference are among the most sensitive terms when determining the value of equity held by VCs and company founders. In comparison, the inclusion of anti-dilution protection in a deal has the potential to exert nearly as large an effect on returns, but is generally much less well understood, particularly by first-time entrepreneurs seeking funding.

I therefore thought I’d use this post as an opportunity to introduce the basics of anti-dilution provisions and what they mean to VCs and common stockholders. I will discuss some common types of anti-dilution protections in a follow-up post next week.

 

What is dilution?

Broadly speaking, dilution occurs anytime new shares are issued in a company. For example, if a particular stockholder owns 100 shares in a company that has 1,000 total shares outstanding, he owns 10% of the company. If an additional 1,000 shares are later issued, the stockholder is diluted since he now owns 100 out of 2000 shares, or 5% of the company.

By the above definition, dilution occurs every time a new financing occurs. When VCs make an investment, they purchase shares which are issued at the time of the financing. This dilutes the percent ownership of all existing stockholders, since new shares are issued. However, if all goes well and each round of financing is accompanied by an increased share valuation, the reduction in the actual percent ownership for each stockholder is more than offset by the increased value of each share.

If, on the other hand, the company experiences a “down round”, i.e. a round of financing that comes with a reduced valuation compared with the previous finance round, the dilution causes a reduction in the actual monetary value of each shareholder’s equity. To protect themselves from this eventuality, VCs often include anti-dilution protections in term sheets.

 

Who is protected and how?

The first thing to realize about anti-dilution protections is that they protect the preferred stockholders from previous rounds in the event of a down round, but do not protect company founders and other common stockholders. In fact, when a VC exercises his anti-dilution rights, it actually causes additional dilution to common stockholders.

The basic mechanism by which VCs are protected by anti-dilution provisions is that the conversion price (the price at which their original investment is converted to shares) is reduced. The actual amount by which the conversion price is reduced is determined by the type of anti-dilution protection in the term sheet, but the basic effect is that the VC gets to purchase shares at a lower price than the original purchase price. So although this helps offset the dilutive effect on the protected VCs, it leads to additional shares outstanding, and therefore magnifies the dilutive effect of the down round for all non-protected shareholders such as company founders and management.

Anti-dilution protections become an even more important factor in a down-economy. Anyone negotiating a term sheet in the current economic climate must carefully consider the anti-dilution protections included. Down rounds have become increasingly common as companies struggle in a more difficult market, so anti-dilution protections are more relevant than ever.

 

Summary

  • All shareholders are diluted whenever new shares are issued, but as long as share valuation increases with each finance round, the dollar value of everyone’s equity stake still increases.
  • In the event of a down round, VCs can exercise their anti-dilution protections which help offset the dilutive effect for the VC.
  • Anti-dilution protections only protect preferred stockholders, and actually lead to additional dilution of common stockholders at a down round.

Venture Capital Terms: The Importance of Liquidation Preference

Liquidation Preference: Who gets paid what?As many entrepreneurs discover when they first begin to seek venture capital funding, VC term sheets can be very complex. Naturally, each term in a proposed deal is subject to negotiation, but it is not always clear which terms have the greatest impact on the company’s shareholders.  I therefore thought I’d highlight one extremely important but often misunderstood deal term: liquidation preference.

Although liquidation preference is nearly as important as share price in determining the value of equity held by a company’s founders, management, and VCs, it is often overlooked by entrepreneurs during negotiation because it is unfamiliar to those who have limited experience with venture capital.

 

What is liquidation preference?

So what is liquidation preference, anyway? Liquidation preference determines the order in which the various shareholders of a company get paid upon the liquidation of the company. When venture firms invest in a company, they generally purchase preferred stock, which means they get to redeem their shares before common stockholders like founders and company management.

The exact amount VCs get to collect as part of this preferred payout is determined by the preference multiple, which is a multiple of the original purchase price. For example, if a VC firm purchases preferred stock with a 2X liquidation preference, then they have the right to get paid double their original investment before the common stockholders get paid anything. It is not difficult to imagine that this preference might be extremely important under the right circumstances. For instance, if a VC has invested $10M with a 2X liquidation preference, and the company sells for anything less than $20M, then the common stock held by founders and management becomes worthless – the VC collects the entire exit proceeds.

 

Participation

Another important aspect of liquidation preference is participation. Many term sheets grant VCs the right to participate with common shareholders pro rata (i.e. proportional to the percent of the company they own) even after they have been paid their preference multiple.

To illustrate what this means, let’s continue the example above. Suppose a VC has invested $10M in a company, with a 2X liquidation preference. Let’s imagine that the VC owns 80% of the company’s shares, the remaining 20% are retained by common stockholders at the company, and the company sells for $25M.

Without participation, the VC gets paid $20M (its 2X liquidation preference), and the remaining $5M is paid out to the common stockholders. In that case, the common receives 20% of the exit proceeds, as might be expected from their percent ownership. If the VC’s preferred stock has participation rights, however, then the leftover $5M is split 80/20 ($4M / $1M) between the VC and the common. So even though the common stockholders own 20% of the company’s shares, they will actually receive only $1M of the $25M sale!

To limit the benefit received by VCs from participation, some term sheets contain a “cap”, a multiple of the original investment at which VCs no longer get to participate until they let the common “catch up” to their ownership percentage. Such caps benefit the common by allowing them to be paid their full ownership percentage, but this requires the company to sell for an amount higher than the cap in order to be effective.

 

Summary

  • Liquidation preference has a potentially huge impact on the payout to common stockholders, and should not be overlooked during negotiation.
  • Term sheets with higher preference multiples and participation rights favor VCs.
  • Those with lower multiples and no participation (or capped participation) are more favorable to the company.

Evolved Capital Goes Live!

After several months of beta testing and lots of great feedback from our users, we are excited to announce that Evolved Capital has officially gone live! We want to thank our community of beta testers for their help and support throughout the beta process.

After integrating the user feedback we have received, we have added many great new features which we think will improve both the power and usability of Evolved Capital. These improvements are too numerous to describe everything, but a summary of some of the largest changes are below.

 

Cap Table Management / Returns Analysis

  • Users can share cap tables and returns analysis graphs with colleagues at the click of a button.
  • Powerful statistical analyses can be generated from term sheets (real or hypothetical) entered into the application. These reports can be exported for use in Powerpoint presentations or meetings.
  • VC Firms can manage their entire portfolio at a glance using our powerful Portfolio Projector tool.

 

CRM / Deal Management

  • MS Outlook integration: Users can now sync contacts and calendar items with our CRM tool from Microsoft Outlook using our easy to use downloadable plugin.
  • All meetings, phone calls, and other communications can now be logged using our Meeting Manager tool.
  • Email correspondence can quickly and easily be tracked from any email client.
  • In our Deal Pipeline tool, users can fully customize the fields that are used to categorize opportunities, and an unlimited number of custom fields can be added.
  • Statistical reports can be generated about deal opportunities by pipeline status or who is assigned to the deal. All user-customized fields are includable in the statistical reports.

Now that we’ve gone live, user feedback is more important than ever! We invite our users to continue providing feedback on how we can improve, and we always prioritize user suggestions above our other development efforts.

For anyone not signed up for an account at Evolved Capital, we invite you to sign up for a free account and give it a try. You can sign up for a free 15-day trial of any account type to try out our full feature set with no credit card required. Please contact us at sales@evolvedcapital.com with questions or to request a demo.

Public Beta Release

After a few months of development and testing, both on our own as well as with a lot of help from our invited beta testers, we are pleased to announce that we are opening the Evolved Capital application to public beta testing!The public beta is open to anyone working at a qualified venture firm, company or law firm. Anyone interested in trying out the application can sign up (free of charge) using the account creation link on our homepage.

The public beta will include all aspects of the application, including our financial modeling and portfolio projection suite, as well as our CRM modules (pipeline management, pipeline statistics / reporting, contact management, etc).

As public beta testing commences, we will continue to improve the application interface as well as our returns models. We are very excited to finally share our application with our whole community, and we look forward to hearing your feedback!