Did you discover a company that aligns with your investment objectives and operates in your area of expertise? It is a match! But wait, the first step to making it official is to offer a formal proposal that includes your investment amount, the type of security you get in return, and a few other necessary details. This document is called a term sheet, and your choice of security will impact your long-term revenue goals and participation in the company's future.
In a recent Keiretsu Forum meeting, Joe Wallin, a Seattle-based corporate lawyer, spoke in-depth about the most popular types of securities in the market, their distinct benefits, and a few crucial things angel investors should consider before putting forth a term sheet.
Before You Build a Proposition – Things to Consider in a Term Sheet
No other piece of paper is as crucial in determining a company’s future as the proposed term sheet for financing. Simply put, a term sheet is a letter of intent (not an offer letter) wherein the company sets out the basic terms and conditions of the investment, the pre-money and post-money valuations, and a few other details. These factors form what we know as the cap table and equity structure of the company, and they are necessary from economic and governance points of view.
Joe highlighted a few things angel investors should consider before proposing a term sheet:
Economics and Governance – The two priorities
Joe advises that investors must look at term sheets from two point-of-views, viz. economics and governance. The economics, or the cost-related side, ensures your earnings, which is what most investors are interested in. The other aspect, governance, is equally important because it is a way to protect your interests. Voting rights, side letters, observer rights, and similar roles and requests are a way to participate in the firm’s operations. They also help guide the business in the right direction, which impacts your economics.
Choose The Right Security Type
Every term sheet has a space for the type of security the investor gets in return for their funding. The type of security selected impacts the specific rights and benefits of the investor.
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Preferred Stocks, Tried and Tested Method For Ownership Stock
Preferred Stocks are forms of equity that offer the right to earn income from the company’s operations. During a liquidation event, preferred stockholders get the first right to a dividend claim versus common stockholders. However, these stockholders get limited or no voting rights in corporate governance.
Joe recalls that when he started as an investor, everybody wanted preferred stocks. These were the gold standard of securities as they offered preferential treatment during liquidation events. Today, however, businesses conduct many small financing rounds where they negotiate the price instead of a lead. Typically, it is five to ten people writing checks ranging from $25,000 to $50,000 and focusing on valuation. Preferred stocks are more viable for companies looking to raise several million dollars with someone helping to set the valuation because the entire process costs a lot of money.
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Convertible Notes, a Short-term Debt Instrument
A convertible note is a debt given to a company that transforms into equity at a predefined event, such as a priced equity round. These notes have a particular interest rate and maturity rate. If the note is not converted into equity by the maturity date, the company is liable to pay the noteholder (investor) their principal amount plus interest. When you are looking to secure convertible notes, it is crucial to consider whether it is pre-money or post-money, the maturity date, and the interest rate.
Several big-name companies have used convertible notes cleverly to grow bigger. Tesla has consistently used convertible debt to fund its operations and expansion plans from 2013 to 2021. They issued convertible notes and took on debt to finance the construction of their Gigafactories. In 2016, Spotify raised $1 Bn in convertible notes to buy time before an IPO and pursue a direct listing, which gave the lenders the option to convert their loans into equity.
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Simple Agreement for Future Equity (SAFE), The New Gold Standard?
Joe remarked during the presentation that “Convertible notes evolved, but probably the most rapidly adopted financial instrument in time, the SAFE came into being.”
Similar to convertible notes, SAFE converts into stock in a future event. However, it is not debt and does not require the company to pay back the investment with interest. This type of security does not have any maturity date, instead, it has a valuation cap or a conversion discount.
Although many investors do not like SAFEs, their biggest advantage is that they facilitate faster transactions, which everybody loves. Its process is also very simple, the investor has to fill in the name of the company, the name of the investor, the date, and the amount of the investment, and then sign the document.
There are other forms of securities, such as common stock and revenue loans, but the above three are the most popular forms of securities in the market.
Beyond The Numbers: Key Insights Into Term Sheets
Liquidation Preference - The Key to Faster Transactions
According to Carta’s State of Investment report for Q1FY24, 88% of companies raised capital via SAFE, as opposed to convertible notes. This is because the notes have a maturity date and a set interest, which makes it a form of debt. However, SAFEs, similar to preferred stocks, are equity in nature. The SAFE investor does not know how many shares they are getting until it converts during a liquidation or dissolution event when they will get preferential treatment.
Since debt is higher on priority than equity, Joe Wallin advises investors to get an MFN (Most-Favored-Nation) with their SAFE, as it will allow the investor to convert their SAFEs into convertible notes whenever the company starts issuing them.
“I think it is missed by both companies and investors that convertible notes are a bridge to further funding. Whereas with a SAFE, there is no obligation to go raise any additional amount of capital,” says Joe.
Cementing Your Role In Company Matters
Some investors may feel that SAFE offers less protection in terms of knowing when the investment will convert to equity. Furthermore, it does not provide pro-rata rights, information rights, or observer rights. In such a case, Joe Wallin advises that investors can request a side letter that grants them relevant rights to the financial statements, future investment rounds, attending board meetings, and so on.
There are also instances where companies raise multiple rounds of SAFEs with higher valuations. The SAFEs have a dividend rule for the investors, so they can choose to invest in another round with the same security. It may cause some unexpected dilution for the founders of the company but the investors can exercise this right if they want to.
How To Minimize The Tax Burden
Section 1202 of the Internal Revenue Code allows investors, not corporations, to exclude up to $10 Mn in capital gains from small business stocks held for more than five years. This is a major incentive to invest in C-corporations with less than $50 Mn in gross assets. The qualifying trades include software and innovative technologies. Personal services such as law, finance, banking, insurance, or professions like engineering or medicine are not included under this law.
About the Speaker
Joe Wallin is a Seattle-based corporate lawyer who has been working in the early-stage company space since the late 1990s. He is an active member of the Angel Capital Association's public policy advisory council, and he is actively involved in advising investors and founders looking to get the best business deals in a compliant manner. Joe has written for The Wall Street Journal, PandoDaily, GeekWire, and Xconomy, and blogs at The Startup Law Blog.
Click here to watch Joe Wallen’s presentation for Keiretsu Forum: Term Sheets & Corporate Transparency Act with Joe Wallin
References:
https://www.vox.com/2018/1/3/16847786/spotify-tpg-tencent-debt-dragoneer-ipo-music-streaming
https://carta.com/learn/startups/fundraising/convertible-securities/#what-is-a-convertible-note
https://www.investopedia.com/terms/p/preferredstock.asp
