{"id":5999,"date":"2020-03-19T00:00:00","date_gmt":"2020-03-19T00:00:00","guid":{"rendered":"http:\/\/www-staging.carta.com\/sg\/blog\/watch-out-for-these-terms\/"},"modified":"2021-03-05T06:55:54","modified_gmt":"2021-03-05T06:55:54","slug":"watch-out-for-these-terms","status":"publish","type":"post","link":"https:\/\/www-staging.carta.com\/sg\/blog\/watch-out-for-these-terms\/","title":{"rendered":"Watch out for these fundraising terms"},"content":{"rendered":"\r\n<p>In the world of fundraising, it\u2019s not uncommon for investors and VC firms to craft term sheets that benefit themselves. For founders, knowing whether you\u2019ve received a \u201cclean\u201d term sheet (one that doesn\u2019t include things that are widely considered investor-favorable terms) can be confusing.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>There\u2019s little education around this topic for first-time founders. Many mistakes are made during seed or series A rounds\u2014when founders are the most eager to get funding and get to work on their idea.\u00a0\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Here are 3 things founders should avoid to retain more upside for themselves and their employees:\u00a0\u00a0<\/p>\r\n\r\n\r\n\r\n<ul>\r\n<li>Anything above a 1x liquidation multiplier<\/li>\r\n<li>Participating preferred stock<\/li>\r\n<li>Full-ratchet price-based anti-dilution provisions<\/li>\r\n<\/ul>\r\n\r\n<p><img loading=\"lazy\" class=\"aligncenter wp-image-1944\" src=\"https:\/\/www-staging.carta.com\/sg\/wp-content\/uploads\/sites\/9\/2019\/06\/centered.png\" alt=\"\" width=\"400\" height=\"266\" srcset=\"https:\/\/www-staging.carta.com\/sg\/wp-content\/uploads\/sites\/9\/2019\/06\/centered.png 1200w, https:\/\/www-staging.carta.com\/sg\/wp-content\/uploads\/sites\/9\/2019\/06\/centered-768x511.png 768w\" sizes=\"(max-width: 400px) 100vw, 400px\" title=\"\"><\/p>\r\n<h3 style=\"text-align: center\">What should clean terms look like?<\/h3>\r\n<p style=\"text-align: center\">Download this Gunderson Dettmer sample term sheet<\/p>\r\n<p>[marketo-form form_id=&#8221;6797&#8243;]<\/p>\r\n<h4 class=\"blogFormSubhead\" style=\"font-weight: normal;margin-top: -20px\">\u00a0<\/h4>\r\n\r\n<p class=\"has-text-align-center has-small-font-size\"><br \/>This term sheet sample has been prepared by Gunderson Dettmer Stough Villeneuve Franklin &amp; Hachigian LLP (Gunderson Dettmer), for informational purposes only. By submitting your email address and downloading the sample, you are consenting to email marketing from Gunderson Dettmer and Carta.<\/p>\r\n\r\n\r\n\r\n<div class=\"wp-block-spacer\" style=\"height: 20px\" aria-hidden=\"true\">\u00a0<\/div>\r\n\r\n\r\n\r\n<h2><strong>Anything above a 1x liquidation preference<\/strong><\/h2>\r\n\r\n\r\n\r\n<p>A <a href=\"https:\/\/www-staging.carta.com\/sg\/blog\/equity-rights-and-liquidation-preferences\/\">liquidation preference<\/a> is a key and common part of a term sheet. It ensures that if a company exits with a lower valuation than expected, the company\u2019s preferred shareholders (i.e., the investors) will receive their money back before other shareholders receive proceeds from the exit.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Generally, the liquidation preference is set at 1x, meaning that in an exit each investor\u00a0must receive their full investment back (dollar for dollar) before the common shareholders can receive anything. If the proceeds are less than the liquidation preference, then all of the proceeds go to the preferred shareholders and the common shareholders receive nothing.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>If the proceeds from the exit exceed the liquidation preference by enough that the preferred shareholders would be better off converting their preferred shares to common shares and receiving their pro-rata share of the proceeds based on their ownership percentage, then the preferred shareholders will receive that greater amount.<\/p>\r\n\r\n\r\n\r\n<p>When the liquidation preference is set above 1x, things can get dicey for founders, employees, and other common shareholders because the company has to exit at a higher valuation before the common shareholders will be entitled to any of the proceeds.<\/p>\r\n\r\n\r\n\r\n<p>Say investors invest $2 million in a company in exchange for 50 percent of the company and they receive preferred stock with a 1x liquidation preference, here\u2019s what the payouts would look like for $5 and $2 million exits:<\/p>\r\n\r\n\r\n\r\n<div id=\"footable_parent_7082\"\n         class=\" footable_parent ninja_table_wrapper loading_ninja_table wp_table_data_press_parent semantic_ui \">\n                <table data-ninja_table_instance=\"ninja_table_instance_0\" data-footable_id=\"7082\" data-filter-delay=\"1000\" aria-label=\"clean-terms-tables-for-blog-post-sheet1-csv.csv\"            id=\"footable_7082\"\n           data-unique_identifier=\"ninja_table_unique_id_7556280_7082\"\n           class=\" foo-table ninja_footable foo_table_7082 ninja_table_unique_id_7556280_7082 ui table  nt_type_legacy_table selectable striped vertical_centered  footable-paging-right ninja_table_search_disabled ninja_table_pro\">\n                <colgroup>\n                            <col class=\"ninja_column_0 \">\n                            <col class=\"ninja_column_1 \">\n                            <col class=\"ninja_column_2 \">\n                    <\/colgroup>\n        <thead>\n<tr class=\"footable-header\">\n                                                        <th scope=\"col\"  class=\"ninja_column_0 ninja_clmn_nm_1xliquidationpreferencenameofchart \">1x liquidation preference (name of chart)<\/th><th scope=\"col\"  class=\"ninja_column_1 ninja_clmn_nm_preferredshareholdersinvestors \">Preferred Shareholders (Investors)<\/th><th scope=\"col\"  class=\"ninja_column_2 ninja_clmn_nm_commonshareholdersfoundersemployees \">Common Shareholders \n(Founders & Employees)<\/th><\/tr>\n<\/thead>\n<tbody>\n\n        <tr data-row_id=\"230\" class=\"ninja_table_row_0 nt_row_id_230\">\n            <td>Sold for $5 million<\/td><td>$2.5 million<\/td><td>$2.5 million<\/td>        <\/tr>\n            <tr data-row_id=\"231\" class=\"ninja_table_row_1 nt_row_id_231\">\n            <td>Sold for $2 million<\/td><td>$2 million<\/td><td>Nothing<\/td>        <\/tr>\n    <\/tbody><!--ninja_tobody_rendering_done-->\n    <\/table>\n                    <style type=\"text\/css\" id='ninja_table_custom_css_7082'>\n                        #footable_7082  {\n        font-family: inherit;\n        font-size: 14px;\n    }\n\n                <\/style>\n                \n    \n    \n<\/div>\n\r\n\r\n\r\n\r\n<div class=\"wp-block-spacer\" style=\"height: 20px\" aria-hidden=\"true\">\u00a0<\/div>\r\n\r\n\r\n\r\n<p>Now let\u2019s say investors put in that same $2 million in exchange for 50 percent of the company but they receive preferred stock with a 2x liquidation preference. Here\u2019s what payouts would look like for those same two exit scenarios:<\/p>\r\n\r\n\r\n\r\n<div id=\"footable_parent_7083\"\n         class=\" footable_parent ninja_table_wrapper loading_ninja_table wp_table_data_press_parent semantic_ui \">\n                <table data-ninja_table_instance=\"ninja_table_instance_1\" data-footable_id=\"7083\" data-filter-delay=\"1000\" aria-label=\"clean-terms-tables-for-blog-post-sheet2-csv.csv\"            id=\"footable_7083\"\n           data-unique_identifier=\"ninja_table_unique_id_1508634014_7083\"\n           class=\" foo-table ninja_footable foo_table_7083 ninja_table_unique_id_1508634014_7083 ui table  nt_type_legacy_table selectable striped vertical_centered  footable-paging-right ninja_table_search_disabled ninja_table_pro\">\n                <colgroup>\n                            <col class=\"ninja_column_0 \">\n                            <col class=\"ninja_column_1 \">\n                            <col class=\"ninja_column_2 \">\n                    <\/colgroup>\n        <thead>\n<tr class=\"footable-header\">\n                                                        <th scope=\"col\"  class=\"ninja_column_0 ninja_clmn_nm_2xliquidationpreferencenameofchart \">2x liquidation preference (name of chart)<\/th><th scope=\"col\"  class=\"ninja_column_1 ninja_clmn_nm_preferredshareholdersinvestors \">Preferred Shareholders (Investors)<\/th><th scope=\"col\"  class=\"ninja_column_2 ninja_clmn_nm_commonshareholdersfoundersemployees \">Common Shareholders (Founders & Employees)<\/th><\/tr>\n<\/thead>\n<tbody>\n\n        <tr data-row_id=\"232\" class=\"ninja_table_row_0 nt_row_id_232\">\n            <td>Sold for $5 million<\/td><td>$4 million<\/td><td>$1 million<\/td>        <\/tr>\n            <tr data-row_id=\"233\" class=\"ninja_table_row_1 nt_row_id_233\">\n            <td>Sold for $2 million<\/td><td>$2 million<\/td><td>Nothing<\/td>        <\/tr>\n    <\/tbody><!--ninja_tobody_rendering_done-->\n    <\/table>\n                    <style type=\"text\/css\" id='ninja_table_custom_css_7082'>\n                        #footable_7082  {\n        font-family: inherit;\n        font-size: 14px;\n    }\n\n                <\/style>\n                                <style type=\"text\/css\" id='ninja_table_custom_css_7083'>\n                        #footable_7083  {\n        font-family: inherit;\n        font-size: 14px;\n    }\n\n                <\/style>\n                \n    \n    \n<\/div>\n\r\n\r\n\r\n\r\n<div class=\"wp-block-spacer\" style=\"height: 20px\" aria-hidden=\"true\">\u00a0<\/div>\r\n\r\n\r\n\r\n<p>In the above example, because of the 2x liquidation preference, investors would get a total of $4 million out of the $5M exit, <strong>leaving just $1 million\u201420 percent\u2014for founders and other common shareholders.\u00a0<\/strong><\/p>\r\n\r\n\r\n\r\n<p>And if the company exits for less than\u00a0the investor\u2019s 2x liquidation preference\u2014in this case, $4 million\u2014the investors would receive the entirety of the payout, doubling their money even though they only own half of the company, and leaving the owners of the other half of the company with nothing.\u00a0\u00a0<\/p>\r\n\r\n\r\n\r\n<p>A liquidation preference above 1x should be a warning sign for first-time founders, as countless have horror stories about how multiple liquidation preferences <a href=\"https:\/\/medium.com\/help-me-heidi\/my-company-sold-for-100-million-and-i-got-zilch-how-can-that-be-f7be0563f1f8\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">left them with nothing.<\/a> Take, for example, Michael Arrington, founder of TechCrunch, Crunchbase, and numerous other companies. When he founded his first company, Achex, a 2x liquidation preference was the industry norm. Though he raised $18 million in capital and sold the company for $32 million\u2014<a href=\"https:\/\/twitter.com\/arrington\/status\/1176985184287088640?s=21\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">he received nothing.<\/a> Thanks to the 2x liquidation preference, he had to make over $36 million to receive anything, and far more than that to receive anything substantial.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Though all founders should expect that their investors place safeguards on their investments in the form of liquidation preferences, it\u2019s imperative that first-time founders in particular are aware of liquidation preferences that exceed 1x. Because one small number on a term sheet could be the differentiator between a founder receiving a return on the company they founded, or walking away from years of hard work with nothing.\u00a0<\/p>\r\n\r\n\r\n\r\n<div class=\"wp-block-spacer\" style=\"height: 20px\" aria-hidden=\"true\">\u00a0<\/div>\r\n\r\n\r\n\r\n<h2><strong>Participating preferred stock\u00a0<\/strong><\/h2>\r\n\r\n\r\n\r\n<p>Preferred stock can be participating or non-participating. Participating preferred means that, when the proceeds from an exit exceed the liquidation preference, preferred shareholders will receive additional cash on top of their liquidation preference.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Say an investor invests $2 million in participating preferred stock for 50 percent of the company. If that same company were to be acquired or sold for $5 million, the investor would receive their $2 million liquidation preference off the top, and then split the remaining proceeds with the common shareholders based on their pro rata ownership (in this case, 50 percent)\u2014which would equal 1.5 million (half of the $3 million remaining after the liquidation preference has been paid). That means the investor walks away with $3.5 million, leaving only $1.5 million left to split between all common shareholders.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Participating preferred stock allows investors to \u201cdouble-dip\u201d and receive their liquidation preference and their pro rata share of the remainder (instead of choosing between their liquidation preference and their pro rata, as is the case with non-participating preferred). This puts more money in the pockets of the investors and gives less of the upside of a successful exit to founders and employees.<\/p>\r\n\r\n\r\n\r\n<h2><strong>Full-ratchet anti-dilution provisions<\/strong><\/h2>\r\n\r\n\r\n\r\n<p>Price-based anti-dilution protection provisions adjust the number of common shares that preferred stock can convert into in the event a company later has a down round of financing. This means that the company sells new preferred shares at a price that is lower than shares of preferred it sold to its earlier investors. These provisions are designed to give investors some assurance that if the company decides to sell shares in the future at a lower valuation (commonly called a \u201cdown round\u201d) than the valuation at which they invested, the existing investors\u2019 percentage ownership won\u2019t be excessively diluted by the new investment.\u00a0<\/p>\r\n\r\n\r\n\r\n<p>Price-based anti-dilution adjustments can be calculated in several ways. The most common is to take a weighted-average (which accounts for the number of shares being sold in the down round as well as the price). These adjustments can also take the form of what\u2019s known as a \u201cfull ratchet,\u201d which effectively reprices the shares of the existing investors with the anti-dilution protection at the down round price.<\/p>\r\n\r\n\r\n\r\n<p>For example, say an investor were to invest $2 million for 50 percent of a company with a $4 million post-money valuation. Assuming the company had 2 million shares outstanding post-financing, the investor would have purchased 1 million shares for $2 per share. However, if the company later raises a down round priced at $1 per share, even if the Company were only to raise $20K in the round, a full-ratchet anti-dilution adjustment would entitle the original investor to receive an additional 1 million shares of common stock upon the conversion of its preferred stock. It effectively lowers the price that they paid for their shares from $2 per share to $1 per share, retroactively. A weighted-average adjustment on these same facts would result in an adjusted price much closer to $2 per share because of how few shares are being issued in the down round.<\/p>\r\n\r\n\r\n\r\n<p>Described as \u201cdraconian\u201d by Scott Edward Walker, founder and CEO of Walker Corporate Law and contributor to VentureBeat, it\u2019s imperative that founders be wary of a full-ratchet anti-dilution clause in a term sheet.<br \/><br \/><\/p>\r\n<h6 style=\"text-align: center\">JOIN CARTA<br \/><br \/><\/h6>\r\n<p><img loading=\"lazy\" class=\"aligncenter wp-image-6980\" src=\"https:\/\/www-staging.carta.com\/sg\/wp-content\/uploads\/sites\/9\/2019\/07\/blog-image-1024x683-1.png\" alt=\"\" width=\"400\" height=\"267\" title=\"\"><\/p>\r\n<h3 style=\"text-align: center\">What should clean terms look like?<\/h3>\r\n<p style=\"text-align: center\">Download this Gunderson Dettmer sample term sheet<br \/><br \/><a href=\"\/events\/webinars\/understanding-term-sheets\/?source=clean-terms\"><button class=\"Button\" type=\"button\">REGISTER NOW<\/button><\/a><\/p>\r\n\r\n\r\n\r\n\r\n\r\n<h2><strong><br \/>Key takeaways<\/strong><\/h2>\r\n\r\n\r\n\r\n<p>There\u2019s no easy way to put it. As a first-time founder, you\u2019re vulnerable to dirty terms. Before going through the funding process, it\u2019s imperative to not only <a href=\"https:\/\/www-staging.carta.com\/sg\/blog\/category\/founder-resource-center\/\">educate yourself on the ins and outs of the process,<\/a> but <a href=\"https:\/\/www-staging.carta.com\/sg\/blog\/founder-guide-law-firm-lawyers\/\">find good lawyers and trusted advisors<\/a>. A big reason to get this right is because your first terms set a precedent and are likely to be given to later investors. As always, we\u2019re here to help you through the fundraising process and beyond, and if you have any questions on how terms will affect you, don\u2019t hesitate to <a href=\"https:\/\/www-staging.carta.com\/sg\/requestdemo\/\">reach out and drop us a line<\/a>.\u00a0\u00a0\u00a0<\/p>\r\n\r\n\r\n\r\n\r\n\r\n<p class=\"has-small-font-size\">DISCLOSURE: This communication is on behalf of eShares Inc. d\/b\/a Carta, Inc. (&#8220;Carta&#8221;), and\u00a0contains general information only. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.\u00a0 This communication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.\u00a0 This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.\u00a0<\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>In the world of fundraising, it\u2019s not uncommon for investors and VC firms to craft term sheets that benefit themselves. For founders, knowing whether you\u2019ve received a \u201cclean\u201d term sheet can be confusing.<\/p>\n","protected":false},"author":87,"featured_media":6000,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":[],"categories":[19],"tags":[],"acf":[],"_links":{"self":[{"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/posts\/5999"}],"collection":[{"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/users\/87"}],"replies":[{"embeddable":true,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/comments?post=5999"}],"version-history":[{"count":0,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/posts\/5999\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/media\/6000"}],"wp:attachment":[{"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/media?parent=5999"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/categories?post=5999"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www-staging.carta.com\/sg\/wp-json\/wp\/v2\/tags?post=5999"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}