This is the second post devoted to equity-round term sheets and the concluding part of my term sheet guide. If you haven’t read the first part on equity term sheets, I strongly recommend doing so before moving on. For a general introduction to term sheets and the trade-off between high valuation and complex investment structure, please refer to theintroductory post to the guide. For an overview of a convertible loan term sheet, please refer to this post.

Let’s dig into the remaining set of terms entrepreneurs can typically find in an equity-round term sheet, which the first post didn’t cover. They are mostly the complex points, which are often misunderstood and can lead to serious quarrels.

The terms

Liquidation preference: a very important clause that is sometimes overlooked by entrepreneurs. It is one of the key terms used to protect an investor’s downside. Generally you will find one of the two variations of the liquidation preference definition in a term sheet: participating or non-participating, or their combination (i.e. capped participating, even though that’s quite rare in my experience).

The easiest way to explain liquidation preference is using an example. Let’s say an investor invested EUR 1,000,000 for 10% stake in the company. If this investor has a non-participating liquidation preference, he has a right to choose at a liquidation event (i.e. exit, or any kind of transaction that involves a buy-out of existing shareholders, not just a bankruptcy sale, which is the most common understanding of liquidation) whether he would like to receive the preferred return specified in the liquidation preference clause or 10% of the exit price. Most typically, the preferred return is equal to the amount invested (in our example EUR 1,000,000), but can be a multiple of that amount (e.g. 2x liquidation preference corresponds in our example to EUR 2,000,000). Let’s say the investor in our example has 1x (also called “simple”) liquidation preference, i.e. EUR 1,000,000. When the company gets sold, he can choose whether he would like to receive EUR 1,000,000 or 10% of the exit price. Using simple math, it makes sense to choose EUR 1,000,000 if the exit price is below EUR 10,000,000, and choose 10% of the company if the exit price is above EUR 10 MM. Likewise, if the investor has 2x liquidation preference (and thus his preferred return is EUR 2,000,000), the exit price at which it becomes interesting to take the 10% of the company instead of the preferred return is EUR 20 MM.

Things get a bit more complicated with participating liquidation preference. In this scenario, the investor at exit first gets his preferred return, and then the rest of the exit proceeds get distributed pro rata among all shareholders. Let’s take the example above: investor has provided EUR 1 MM for 10% of the company with 1x participating liquidation preference. If the company gets sold for EUR 10,000,000, the investor first gets EUR 1 MM, and then also 10% of the remaining EUR 9 MM for a total of EUR 1.9 MM.

In general, we tend to stick with simple 1x non-participating liquidation preference, which is the most entrepreneur-friendly alternative. Entrepreneur-friendly liquidation preference is also important for attracting future investors or exit partners, who don’t want to see a disproportionate amount of acquisition price going to investors as opposed to entrepreneurs. Nonetheless, if the entrepreneur has unreasonable valuation expectations, we tend to include stricter liquidation preference (2–3x non participating). We recently (and after a heated debate) decided not to use participating liquidation preference in the future, since we consider it too entrepreneur-unfriendly. Simply put, if we can’t reach an agreement on acceptable valuation, we would prefer to walk away from a deal rather than include harsh terms that can cause fights between founders and an investor and deter future investors from investing.

Drag along right: this right allows an investor (or, in case a startup has multiple investors, after agreement among all existing investors) to drag all remaining shareholders (including the founders) to sell their shares if the investor decides to sell his. Typically, this right can only be exercised after certain time period; standard is between 1–3 years after the transaction. Sometimes, the execution of a drag along right has to be approved by startup’s board of directors.

A lot of entrepreneurs worry about this right and it is easy to see why: at first glance, it seems that the investor can decide the fate of the company without consulting the founders. What the founders must realize is that no buyer will buy a company if they don’t want to sell, because the founders and their team are an essential part of what the acquirer is buying. That’s why a drag along can only work in practice if it also endorsed by the founders. We at Credo have never exercised a drag along right before, but still want to have it in the term sheet. It is for the unlikely event that some shareholder (typically a non-essential one, such as a fired angry early employee who has a stake in the company and wants to damage it) will try to block a transaction.

Founder’s vesting: another right that deals with founder quarrels. Essentially, when founders take an outside investment, they will not own their entire equity outright. Instead, it will vest over time. If you are not sure what vesting is, please read Fred Wilson’s post.

Let’s describe the mechanics in an example. Our typical terms are the following: at signing, each founder directly owns 30% of his stake. The remaining 70% of the stake gets vested over the next 4 years. How does this look in practice? Let’s say a founder is supposed to own 50% of the company once the investment is made. According to founder’s vesting, he will own 50% * 30% = 15% of the company outright. In two years, he will own 50%*30%+50%*(1–30%)*(24/48 months)= 32.5%. In four years, he will own the full 50%.

At first glance, this may seem like a very entrepreneur-unfriendly clause. Nonetheless, we use it especially in our seed investments, where the founders are working on their first venture together. It has a simple reason: let’s say there are four founders, where each owns 25% stake in the firm. There are plenty of real life cases where one of the founders gets in an argument with others and leaves. If there is no founder’s vesting, all of a sudden you have a 25% shareholder in your company who not only doesn’t add value to the firm, but may be angry and on a mission to sabotage the rest of the firm just to get back at you. Founder’s vesting thus helps mitigate the consequences of founders’ quarrels.

Reporting: be prepared that an investor will typically want to see a monthly report, or at least a quarterly one in very early stages of startup’s lifecycle. In general, this includes monthly income statement and balance sheet (which your accounting firm can produce) along with a short qualitative commentary from the CEO about most important news of the month. These materials also serve as supporting documents for a board meeting.

Closing remarks

These terms might initially seem quite controversial. That’s why it is very important to sit down with the VC who offered the term sheet, and let him walk you through the logic of each term. If something sounds fishy to you, it is very easy to Google each of the terms. Plus, if you really want to take a deep dive on term sheets, you can always order some literature on it. I can recommend this piece by Alex Wilmerding.

Some people say that accepting an investment from an outside investor is like getting married. It is true that you might spend more time with your investor than with your wife or husband. If that is so, signing of a term sheet is like getting engaged. How often do you see couples starting a happy relationship by having a long argument? Just keep that in mind when you will be negotiating the term sheet. The way you start the relationship with your investor might be very indicative of where it might be heading.

This is the second part of my mini series focusing on term sheets. For a general introduction to term sheets and the negative consequences of pushing for high valuations, please refer to the first post.

Before we dig into individual terms, it is important to distinguish between the two most common methods of investing: convertible loans and equity investments. In an equity investment, an investor receives a stake in the company in exchange for cash. Plain and simple. If the investor provides a convertible loan instead, he will provide a loan with a maturity date, interest and a special twist: the right to convert the loan into an equity stake in the company at some point in the future.

The goal of this post is to cover the convertible loan – in general the less commonly used investment method. Nonetheless, it typically contains just a few terms that can easily be covered in a single post.

Definition of a convertible loan

As mentioned above, a convertible loan is short-term debt that converts into equity. Usually it converts at the next investment round. Example: if you receive your seed investment in a form of convertible loan, it will convert to equity when you raise your Series A investment.

The advantage from the perspective of an entrepreneur is that a convertible loan before its conversion behaves very much like a standard loan: the investor typically does not have many of the rights of a preferential shareholder (board seats, liquidation preferences, etc.). Since it is a fairly short and simple document, it also gets executed faster (that’s why convertible loan investment can be processed faster than an equity investment, typically by a couple of weeks). Additionally, a standard convertible loan does not require an immediate payment of interest. Instead, it gets accrued and converted to equity, as explained below.

The disadvantage also comes from the very nature of the loan: until the loan gets converted to equity, the investor has a priority right at maturity date to claim any assets (i.e. cash & hardware for most startups) in order to get the loan and interest repaid. Needless to say, most startups don’t have enough cash to repay the loan at maturity and thus are forced to liquidate all assets and close down the business.

Why and when to use a convertible loan

There are a couple of scenarios when a convertible loan can be used. First, it may serve as a source of “bridge financing” before an anticipated large financing round. Say you raised a EUR 200,000 seed round and are now in the process of raising EUR 2 MM Series A, but still need a few more months to complete the round. So you take a EUR 100,000 convertible loan as an extra cushion for the fundraising process. As mentioned above, convertible loans are faster to execute from a legal perspective, so the whole transaction can get processed in a matter of few weeks. Bridge financing can be tricky, though: if investors are not 100% convinced that things are going well, asking for a quick convertible loan may give rise to major concerns regarding performance and outlook (i.e. the question: why would you need more cash in order to fundraise?). Losing existing investors’ confidence is a very bad way to start the fundraising process.

Second, the convertible loan is used at times when investors and entrepreneurs can’t agree on valuation, especially when they define a conversion discount but not necessarily the valuation cap (explained below). I am not a big fan of this use case: instead of facing a major issue straightaway, both parties decide to shift its resolution to some later point in time. Such a strategy can very easily backfire, creating nasty arguments between investors and entrepreneurs, which can block further fundraising and thus kill a startup.

Convertible loans are also increasingly being used at the seed stage. There is plenty of criticism against this practice from VCs, especially if the notes are overused and include harsh terms. I recommend reading this piece by Mark Suster on the topic.

Terms you can find in a convertible loan

Maturity date: This is the time by which the loan matures. First thing to understand: the investor can require the repayment of the loan at the maturity date. This is used to protect his downside: if the startup is not doing well, the investor can still recoup his investment and interest at the loan’s maturity date (and kill the startup if it doesn’t have enough money to repay the loan).

Interest rate: This is the interest the startup shall pay on the loan. It is typically a PIK (payment in kind) interest, i.e. startup doesn’t actually pay the cash. Instead, interest gets accrued to the principal of the loan. In such case the accumulated interest gets converted into equity together with the principal of the loan. Example: if you raise a EUR 100,000 convertible loan with an 8% interest that gets converted into equity in 12 months, the actual amount that gets converted is EUR 108,000. The most common rates we have seen hover between 6–8%.

Conversion: very important clause that describes the conditions under which the loan is converted to equity. The most typical mandatory conversion scenario is upon “qualifying financing”: once a startup raises more than EUR XX (i.e. raises a “qualifying financing” round), the loan under gets automatically converted into equity. The most investor friendly alternative for conversion is at any time the investor chooses, but this scenario is very rare if the startup has raised additional capital. Typically, if the startup doesn’t raise any new capital before maturity date, the investor has a right to decide whether he wants to convert or not.

Qualifying financing: the minimum amount a startup has to raise in the next financing round in order for the convertible loan to be automatically converted to equity. The amount varies widely depending on whether the startup is raising seed, Series A or more later-stage capital.

Conversion discount: The investor typically converts his loan to equity with a conversion discount in valuation compared to new investors to compensate him for the additional risk of having entered the startup earlier than the new investors. Example: Say new investors are entering the startup at EUR 5,000,000 valuation. If the note has a 20% valuation discount, the holder of such a loan can convert the entire amount of the loan (and interest as explained above) to equity at 5,000,000 * 80% = EUR 4,000,000. A standard discount we typically see on a convertible loan is between 10–30%, with 20% being the most common.

Valuation cap: In addition to a conversion discount, investor can also set a valuation cap, i.e. the maximum valuation at which the loan will convert. Let’s use the example above, but say that the terms also included a valuation cap of EUR 3,500,000. Without the cap, the investor would convert at EUR 4,000,000 valuation, but with the cap, the investor can convert at EUR 3,500,000.

These are the most common terms an entrepreneur can find in a convertible loan, at least based on what we at Credo Ventures have experienced.

Nevertheless, we tend to prefer equity rounds: rather than hiding/avoiding terms or valuations, we agree on the whole structure at the beginning so we can focus on what is important: creating value for the startup. More on how we set the structure and how we think a fair equity round term sheet should look in the next post.