Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process. In this series we’ll look to shed some light on the legal language contained in a financing term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both the Company and the Investor.
Last week we gave an overview of just what a financing term sheet is and why it is important (check it out here if you missed it). This week we begin our first real “deep dive” discussion. To start us off, we’ll consider the top line item, the one of most concern to both Company and Investor alike: What is the price of the stock being sold? (Or, by corollary, how much of the Company does the current ownership have to “give away” in exchange for the investment?).
What we will see is that the answer to that question all comes down to what the parties “value” the Company at prior to investment: the “pre-money” valuation.
The NVCA term sheet we are using as our roadmap for these discussions (attached below) uses very little legal language to describe the valuation concept. The entirety of the idea can be found in three separate sections: “Amount Raised”, “Price Per Share”, and “Pre-Money Valuation”. They are stated as follows (with specialized language omitted for purposes of discussion):
Amount Raised: $[________]
Price Per Share: $[________] per share
Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization).
So let’s break this down. “Amount Raised” is simple enough. If a Company has determined that it needs 10 million dollars: the “amount raised” will be 10 million dollars.
“Price per share” and “Pre-Money Valuation” are actually component answers of the same question: If I, the Investor, give you 10 million dollars, what should I get in return?.
Since what the Investor is buying is actually a percentage interest in the Company, the answer naturally flows from a determination of what the Company is worth: the pre-money valuation. If a Company is worth 40 million dollars “pre-money” and I invest 10 million more, then after the fact (“post-money”) it will be worth 50 million dollars and I should hold 20 percent (10/50) of the “fully diluted” equity of the Company. Simple enough.
What does that 20 percent look like? That’s where the concept of “fully-diluted” comes in. The “fully-diluted” equity of a Company is not just the shares of stock (or membership interests) that a Company has actually issued (though those are included). It is also all of the Company’s promises to issue stock in the future. Generally speaking, we refer to the entirety of this concept as the Company’s “capitalization”.
So if a Company has “reserved” 10,000 shares of stock for issuance to its employees as incentives, those shares are counted as outstanding when calculating the shares that must be issued to the Investor to result in the Investor holding 20% of the Company’s equity after its investment. Similarly, any options or warrants to purchase stock count against this number, as do any other instruments (notes, contract rights, etc.) that evidence a future commitment of the Company to issue stock.
It is also for this reason that you see the concept of the Company’s stock option pool in the sample term sheet (in connection with the valuation). The Investor has incentive to ensure that the Company is treating its employees right (by creation of an adequate pool), but, if possible, it will want to ensure that its investment is not diluted by changes in the pool immediately after buying the Company’s stock.
Once the pre-money valuation and fully diluted equity of the Company have been established, the “price per share” is a simple function. Divide the amount raised by the number of shares to be issued, and out pops the per share price.
At the end of the day then, since the amount raised and the capitalization of the Company are static (or relatively so), all of the rest of the economics flow mechanically from that initial pre-money valuation of the Company. If a Company is worth 40 million and I invest 10 million, I should get 20%. If we decide the Company is worth 10 million then I should get 50%. 90 million, 10%. And the capitalization of the Company will dictate how many shares need to be issued to arrive at that percentage.
Everything comes down to valuation.
It’s worth noting that valuing a private company (a company with equity that is not publicly available on a stock exchange) is a very difficult thing for even the most sophisticated of investors, and that like all “unique” goods a Company’s estimated value can vary wildly (by 10s of millions of dollars, or more) depending on who one asks. Like all things, there is only one certain valuation after all the dust has settled – the price that someone is willing to pay for it.
(If you are interested in additional discussion on valuation concepts from a legal compliance perspective, I recommend reviewing IRS Revenue Ruling 59-60 (on valuations in the context of gift and estate tax liability) and the final regulations governing IRS Rule 409A (regarding the valuation of stock in connection with incentive compensation plans; search for “illiquid stock”) These are not strictly related to the concept of purchasing stock in a financing, but can give insight as to what concepts “the professionals” look at when trying to put a price on the unpriceable.)
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing needs please don’t hesitate to leave a comment down below or contact me at www.hoeglaw.com.