Survive the Term Sheet Negotiation and Investor Due Diligence Part 1

DAVID S. ROSE , FOUNDER AND CEO , GUST INC.

28 Nov 2023

[The following is an edited excerpt from David S Rose’s book The Startup Checklist: 25 Steps to a Scalable, High-Growth Business.]

In Chapter 19, we noted that one of the principal roles of the lead investor was to negotiate the terms of an investment with the founder of the startup. In theory, the terms could be “here’s a million dollars to use; if the company becomes a big success, please give it back to us.” Unfortunately, that’s not the way it works.

The Different Types of Equity Investments

When a corporation is established, its ownership is divided into pieces called shares of common stock, as we discussed in Chapter 9. That’s what you as a founder will have, which is why it’s also known as founders’ stock.

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There is a different kind of stock that investors can choose to purchase, called preferred stock. While the name makes it seem preferable to common stock, preferred is not inherently better, it’s just different. Here’s why:

When the time comes to turn the value of the company into cash (during an exit), that cash may be more or less than the value that you and the investors agreed the company was worth at the time of the original investment. That is where the difference between the two types of stock is critical.

Preferred stock is paid out first before any common stock is paid-but it gets back only the amount that was paid for it (plus perhaps some dividends, which for this purpose act like interest). In contrast, common stock gets paid out only after all the preferred has been satisfied—but it gets its proportionate share of all the remaining value.

What this means is that, if you were an investor, you would want to own common stock if the company turns out to be a smashing success (because you get to share in the upside), but you would want to own preferred stock if the company is sold at a loss (because then you have a chance to at least get your money back before the founder sees a penny). What investors in startups buy is actually a hybrid type of stock, called convertible preferred stock, which lets them have their cake and eat it, too.

The primary feature of convertible preferred stock is that in an “up” scenario it converts into common stock, and everyone is happy.

If a “down” scenario occurs, it works differently: The first money that comes in goes to pay off the cash that the investors put in. Anything leftover goes to the holders of common stock. The effect of this is to adjust retroactively the nominal value assigned to the founders’ contribution.

At a basic level, the purpose of different classes of ownership in startup companies is to ensure a match between risk and reward for founders and investors coming in at different times under different sets of conditions. Because the common and convertible preferred stocks are separate types of shares, the company’s charter and other documents can (and usually will) be amended to give different rights and privileges to the different types of stock…typically in the form of protective provisions for the investors.

I’ve included a sample convertible preferred term sheet in Appendix D, with detailed annotations that explain what each of the provisions mean, and why you should care about it.

Note Financing

Selling stock is not the only way you can raise money from investors. Instead, you can borrow money to help get the company off the ground.

The Note…
The key difference is that borrowing money results in a fixed payback to the investor regardless of whether good or bad things happen, while selling equity makes the investor a partner, and his or her payback becomes variable: anything from $0 (if the company goes under) to billions of dollars (if the company ends up worth a lot of money).

Debt has its advantages to a lender—primarily, the certainty of return—and advantages to the borrower—primarily, not having to share any upside in value as the company grows. But startup investors aren’t interested in ordinary debt with its attendant low returns. Instead, they always want to own an equity share of the company (and therefore its upside potential), which is why they’re willing to take the risk of dealing with a startup in the first place.

However, to avoid the cost and complexity of documenting an equity round (which is much more complicated than simple debt) while still providing investors with the enticement of being able to participate in the upside of equity ownership, it is not uncommon these days for startup funders to loan a startup seed money through a hybrid investment vehicle known as a convertible note (where “note” is the technical term used to describe the document that sets forth the terms of the loan).

Is Convertible…
A convertible note carries with it the promise that, at some future point, the angel will be able to convert what started out as a loan into the equivalent of cash, and use that money to buy stock in the company. This can be useful, quick, and less expensive for the company and the investor, but it creates complications. Here’s why:

If the investor is putting $100,000 into your startup in the form of a loan, the only thing you need to discuss is the interest rate that the company will pay to the investor for using his or her money until it gets paid back. On the other hand, if the investor is putting $100,000 into the startup in the form of equity, you need to decide what percentage of the company’s ownership the investor will end up with in exchange for the investment. To figure that out, we use the following math equation:

[Amount being invested] ÷ [company value] = [percent investor ownership]

Since we can calculate any one of the three terms if we know the remaining two—and since we already know how much the investor is putting in ($100,000)—in order to figure out what their ownership percentage will be after the investment, you and the investor simply need to agree on what the company valuation is (or will be) at the time he or she purchases his or her shares of stock. You would negotiate a valuation figure you are both willing to live with. Then he or she would give you the money today, you’d give him or her the appropriate percentage of the company’s stock, and you’d be all set.

But that’s not what you’re doing when you raise funds using a convertible note. Instead, you are borrowing the money today with the understanding that the investor will be able to convert that money into its equivalent in stock someday.

Because that conversion will happen at some point in the future (while you’re getting the money today), you need to figure out a few things today, before the investor will be willing to give you the money. Specifically, you need to decide (1) when in the future the debt will convert to equity, and (2) how the valuation of the company will be determined at that point.

The answer to both questions turns out to be the same: You and the seed investor will wait until a larger, more experienced investor—such as a venture capital fund—agrees to buy equity in the company. At that point, the debt will convert into equity (which answers question 1), and you will use as the valuation whatever the new investor is using (which answers question 2).

And Discounted…
So far, so good. But you’re not quite done. The fact is that the angel investor was willing to invest in your startup at a time when that other investor was not, and you (hopefully) used their investment to make the company more valuable (and therefore got a high valuation from the other investor). Although it would be better for you, it really doesn’t seem fair that your first investor should bear the early stage risk, yet get the same reward as a later stage investor.

You solve this problem by agreeing that the first investor will get a discount to whatever valuation the other investor sets, which is why we call this a discounted convertible note. The discount is typically set at anywhere from 10–30 percent of the next round pricing.

And Capped.
OK, that’s better. But although that sounds fair, it really isn’t (or at least serious investors don’t think it is). That’s because the more successful you are at using the original seed money to increase your startup’s value, the higher the valuation the second investor will have to pay. Pretty soon, the little discount the first investor is getting doesn’t seem so fair after all. For instance, if the big investor would have valued your startup in its early days at $1 million, but is willing to invest in your now-much-more-successful company at a valuation of $5 million, that means you were able to increase the company’s value by 500 percent using the original investor’s seed money.

If the convertible note says that it will convert at a 20 percent discount to that $5 million (if you do the math, is $4 million), the investor would seem to have made a very bad deal. Why? Because she ends up paying for your company’s stock based on a $4 million valuation, instead of the $1 million it was worth in its early days when he made the risky investment.

The way the industry has solved this problem is by saying, “Okay, because the angel is investing early, she’ll get the 20 percent discount on whatever valuation the next guy invests at. But to be sure that things don’t get out of hand, we will also say that, regardless of whatever valuation the next investor gives, in no case will the valuation at which the angel’s original debt converts ever be higher than $1 million.” That figure is known as the “cap,” because it establishes the highest price at which the debt can convert to equity. And that’s why this form of debt investment is called a “discounted convertible note with a cap.”

Continue to Survive the Term Sheet Negotiation and Investor Due Diligence Part 2

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