Equity deal terms should be thoroughly understood before choosing to make an investment in a startup. There are multiple combinations, and every equity deal is unique. So how can investors understand the specific terms of the equity deal? How do they understand the varying terminology and language used within these term sheets? In this blog, we will cover what they are, the most common structures, and the implications and specifics investors should be aware of.
What are Equity Deal Terms?
Equity deal terms come in the form of a term sheet – a summary of the desired terms and conditions of the deal. Term sheets are not typically legally binding contracts unless the term sheet includes explicit language that it is a legally binding contract. Rather, it can serve as a framework for soliciting investments and also serves as the guidelines for the final binding contract.
Term sheets can be long and complex and are typically filled with legal jargon that is not easily understood by less-experienced investors. Term sheets can contain any and everything up to the price per share, the size of the funding round, liquidation preferences, anti-dilution protection, and the equity deal structure. There is no set list of items that should be included in a term sheet, meaning that there can be substantial differences between each term sheet.
Equity Deal Structures
While each equity deal has different specifics, there are two basic equity deal structures that are common across all deals: straight priced equity or a derivative security. These encompass a vast majority of equity deals and are important for investors to understand.
The first major equity deal structure is straight priced equity. In this case, investors are directly purchasing equity in the company for cash at a pre-determined price. Straight priced equity can take the form of common stock or preferred stock, and the price can be expressed as a company valuation, price per share, or both.
On the other hand, the other major equity deal structure is a derivative security. Derivative securities are purchase contracts that contain a provision that allows for conversion to equity at some point in the future. The amount of stock and the price per share calculation is determined at the point of sale of the derivative, and sometimes the future date of conversion to equity is determined at that point as well. Common forms of security derivatives include SAFEs (Simple Agreements for Future Equity), warrants, option grants, or convertible debt deals.
Straight priced equity deals occur most commonly and make up the biggest percentage of deals. While there are many differentiating factors between various equity deal structures, most structures fall into these categories of straight priced equity or derivative securities, making the structures a little easier to comprehend.
Key Variations of Deal Types
At the core, variations between different deal types primarily break down how the key risks are divided between the company and the investors. By customizing the preferred stock terms and contractual rights, the risks can be allocated between the founder and investors. The main variables that are customized for preferred stock equity deals include:
- Pre-money valuation/purchase price – the worth of the company before new financing is secured/the price per share an investor pays
- Size of round – the total amount of funding the company desires to secure
- Liquidation preference – the order of which investors receive a return, if any, upon liquidation event, such as a merger or acquisition
- Board seats & approval rights – the number of board seats available to certain investors and the ability for investors to purchase additional stock shares
- Information rights – the right for investors to receive information such as financial statements and other sensitive company information
- Anti-dilution – clauses that shield investors from their investment potentially losing value as the company completes additional funding rounds by providing for the issuance of additional shares to maintain a stated ownership percentage
- Participation rights – a contractual relationship between the issuer and the investor which gives the investor a monetary property right in relation to the issuer
- Redemption rights – a feature of preferred stock that allows investors to require the company to repurchase their shares after a specified amount of time
For convertible notes, the differentiators are less, but they may include less protections than preferred stock. The customizable variables for convertible notes include:
- Size of note – the total amount of funding the company desires to secure
- Maturity date – the date on which the principal and any accrued interest of a fixed income instrument is due to be repaid to investors
- Interest rate – the amount a lender charges a borrower to borrow the money – typically expressed as am annualized percentage of the principal
- If conversion price is capped (valuation cap) – if investors are entitled to equity priced at the lower of the valuation cap or the pre-money valuation in the subsequent financing
- If there is a discount on the conversion price – if investors have the right to convert the amount of the convertible debt, plus interest, at a reduced price
- If there is a liquidated early exit premium – if there is an additional fee charged to investors in the event of the convertible note not converting to conversion shares prior to repayment
- If there is a noteholder’s agreement with some governance and information rights – if governance and information rights mentioned under preferred stock deal also apply to convertible notes
Areas of Concern for Investors
Similar to equity deal structures being grouped into two major categories, areas of concern can also be broken down into five major areas of concern for investors. To further simplify equity deal terms, the five major areas of concern include the deal economics, investor rights and protections, investment management governance and control, liquidity, and exit strategy.
Deal economics are reviewed by investors to determine if they are able to secure a large enough equity position to make their investment worthwhile. This will transparently show when they can potentially expect a return, the order of which investors get paid back, and may include an antidilution provision to prevent employee options from diluting the investors’ investment.
Investor rights and protections are exactly what they sound like – the rights that an investor holds, and the protections they receive for their investment. This can help protect against dilution in future rounds. To read more about dilution in equity deals, check out our blog post about Equity Dilution in Startups.
Investment management governance and control provisions specify the frequency at which investors can expect to be informed of company decisions and updates, the size of investment that will allow investors to have a say in critical decisions, and protection of the investor against potentially damaging company behavior.
It’s important to note that investor rights and protects and investment management governance and control provisions cannot offer any guarantees against a decline in investment value or a total investment loss.
Liquidity specifies when investors could potentially expect a return on their original investment, if they receive a return at all. Liquidity will also specify the order of which investors are repaid after an exit event based on the form of stock the holder owns, called the liquidation preference. These may also include preferred stock participation rights, which typically offer repayment provisions preferable to and in advance of those applicable to common stock. This area of concern can help investors maximize the chance to recoup the original investment.
Exit strategy is the final area of concern investors should be aware of. The exit strategy outlines the “triggers” of an exit event and provides a clear pathway to potential exit. An exit event can take the form of acquisition, merger, IPO (Initial Public Offering), or stock buyback.
These areas of concern should be carefully contemplated when choosing to make a startup investment, as each area can greatly impact the considerations of each investment. By having a holistic view of the potential implications and specifics, investors can be confident in their assessment of the term sheet before choosing to make an investment.
Putting it All Together
While term sheets and equity deal terms can vastly differ deal to deal, the specific components and structures can be simplified in a more digestible way, through the common groupings across deal types. Understanding equity deal terms, the varying structures, and the potential implications of each type is valuable for any investor, seasoned or otherwise.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.