Thirtieth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.
My recent posts in this series have offered thoughts on what to write in pitch documents aimed at VCs. If those documents are written well, and your business idea is a good one, and you are impressive, and you are lucky, and, and, and… then you will hopefully be on the receiving end of a termsheet, and ideally more than one. A termsheet is usually a longish document of 3-10 pages with many clauses and terms. In this post I list the most important of those and explain what they mean. A lot of what you read below is drawn from the excellent Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist by Brad Feld and Jason Mendelson which I thoroughly recommend to anyone thinking of doing a venture deal.
First up, some categorisation. The ‘terms’ in ‘termsheet’ can be put into four buckets:
- Terms which drive the economics of the deal – the most important of which are valuation, liquidation preference and anti-dilution
- Terms which pertain to control of the company post investment – the most important of which are board structure and protective provisions
- Clauses which are legally binding on signature of the termsheet – the most important of which are exclusivity and costs
- Everything else – which don’t matter that much
Second up, an explanation of each of the key terms.
There are five numbers associated with the valuation, the pre-money valuation, the amount raised, the post-money valuation, the share price and the dilution. They are linked by the following equations:
Pre-money valuation + amount raised = Post-money valuation
Share price = pre-money valuation / number of shares in issue pre the round
Dilution = amount raised / post-money valuation
So, if a company is raising £5m Series A round at a £10m pre-money valuation (sometimes shortened to ‘£10m pre-money’ or even ‘£10m pre’) then the post-money valuation will be £10m+£5m=£15m and the dilution will be £5m/£15m=33%. If our hypothetical company had 1 million shares in issued before the round then the share price will be £10m/1,000,000=£10.
The dilution, which is also equal to the new investors stake, is the amount by which the existing shareholders see their percentage stake fall – so if prior to the deal our hypothetical company had four founders each with a 25% stake then their percentage holdings would all fall by 33% to 17%. However, even though the percentage stake held by each of the shareholders would drop, the value of their holding in pounds may well have risen, as the value of the holding equals the number of shares they own multiplied by the share price.
In this example each of the founders owns 250,000 shares (one quarter of the shares in issue before the round) and at a share price of £10 their stake is worth £2.5m. After the round when their percentage holding has dropped to 17% they still own 250,000 shares which are still worth £10 each and £2.5m in total. At least on paper .
Moreover, if the share price of the investment round is higher than a previous round the value of each shareholders stake will have increased despite the fact that the percentage stake has dropped.
The important thing to take away here is that during a VC round new shares are issued and because the value of a stake is a function of the number of shares held and the share price that value may have increased even though the percentage stake has dropped. (The percentage stake remains an important way to quickly estimate the value of a holding in an exit scenario when the number of shares in issue remains constant, although any liquidation preference will have to be taken into account – more of that in part 2.)
This decoupling of value and percentage stake is a very important but somewhat counter-intuitive point for many, but it is a crucial one to understand for anyone who aspires to raise VC.
Many termsheets will include a cap table which describes the share structure after the round which captures much of the information and logic described above. The post investment cap-table in our hypothetical example would look like this:
I will provide similar explanations of the other key terms in the second part of this post in a fortnight.