This is the second of four parts in this series.
When your company is raising money, you may be focusing on what that investment can do for your business. However, you need to understand what you're giving investors, and what they are providing in return. Here are some essential terms to understand, straight from a term sheet.
1. Price Per Share: The “price per share” of the investor term sheet determines the price investors will have to pay per ownership share in the company. The total purchase price of the percentage of the company the investors paid for will be divided by the total number of shares. Conversely, if you multiply the price per share by the total number of shares issued to the investor, you will get the get a number equal to the total investment.
2. Dividends: This term determines the investors right to dividend payouts by the company and who gets priority when dividends are issued. Also, the shares that are issued to the investor determine whether his shares receive dividends or not. However, dividends may not be an ideal way for investors to see a return on their investment, so it’s not the most popular profit-sharing system amongst the company’s owners. There are three primary alternative methods for issuing dividends. The first option is to for the shareholders to be paid dividends in which the cash value of those dividends can be converted into common stock. In other words, the value of the dividend pay out can be converted into equity based on the value of the company’s common stock at the given dividend payout period. The second option is when the owner of the shares receives a cumulative dividends. The owner of the stock accrues dividends paid to him/her over the course of his/her ownership of the stock. In the event of the company’s liquidation or initial public offering (or upon redemption of the stockholder if agreed upon by both parties), the cumulative value of the dividends will be added up. The shareholder will have the right to a cash payout or conversion of the dividends to common stock that is equal to the sum. The last option is more traditional dividend payout scheme. The shareholder will receive dividends from their stock when the company decides to declare dividends. These will be paid to shareholders’ in the form of cash. Of course, the magnitude of value for all of these options (and any mix of these options) is determined by the amount of stock owned by the shareholder.
3. Liquidation Preference: Typically, liquidation of the company results when their is a liquidation event. A liquidation event is a sale, lease, licensing or transfer of the company’s assets to another entity, or its the disposal of the company’s assets (in the case of bankruptcy). Liquidation preferences generally deal with the investors exit strategy if the company is bought by another, IPOs, or is dissolved. Liquidation preferences determine how the investors will get paid in relation to the magnitude of their ownership (how many shares they own) and the rights of their shares’ classes. Different classes of stock may confer different rights at a liquidation event. There are three common alternatives that can be laid out in an investors term sheet for such an event. The first, non-participating Preferred Stock, gives the owner of the shares first right to a cash payout equal to the cash value of the original purchase price of the shares plus any dividends, whether accrued, declared, or unpaid. The second alternative is similar to the first except it reserves the shareholders’ right to convert the dollar value of the previous option to common stock at fair price. This can be important to investors if they believe that the company will one day IPO; they may make a higher return on their investment if they hold onto the stock of the company once it becomes publicly traded. The third alternative is similar to the second. The investors are entitled to the original purchase price of the stock as well as all dividends. The dollar value of such can be converted into common stock, with a cap. This means investors can cash out once their investment reaches a certain value.
4. Voting Rights: An investor will most likely require voting rights when taking part ownership of the company. The shares issued to the investor would confer the voting rights of the shares to the investor or whomever the investor appoints. Certain classes of stock may confer voting rights, while others may not. This nature of voting rights in relationship to ownership of the company or classes of stock is up to the discretion of the investors and founders of the company. Investors can also require that certain decisions, like significant expenditures or practices out of the norm, require approval of the shareholder, even if they do not occupy the majority of the board.
Stay tuned for Part 3 of Understanding the Investor Term Sheet, coming soon!