Module 5: Closing the Deal

We'll teach you how to review a term sheet, the difference between preferred equity and convertible notes, and tax implications to look out for.

By MEGAN ANANIAN

So you’ve decided you want to invest in a company. Now what?

First, you’ll want to review a term sheet. Typically, the lead investor will set the terms and conditions for all other investors (including angel investors and other venture capital firms) coming into the round. The term sheet outlines the details of the investment, such as the company’s valuation, the investment security (SAFE, convertible note, or equity), and any rights you have as an investor. 

Term sheets are non-binding and serve as a template for the official legal agreements to be drawn up after the lead investor’s diligence has been performed. The goal of the term sheet is to give the lead investor and the company an outline of the key points of the investment before turning things over to lawyers to make it official (and add 100 pages of legalese). There are a number of standard clauses that can be included in a term sheet, and understanding these clauses is a good first step towards making sure you, the investor, feel comfortable investing on the terms outlined. While you should become familiar with term sheets, it’s always best to work alongside a lawyer to ensure the terms are favorable. Keep in mind, even seasoned institutional investors can make mistakes, so having your attorney review these documents—especially in the earliest days of your investment journey—is always a good idea. Keep in mind, however, that unless you are the lead investor, negotiating a term sheet is unlikely, and as Claire Logan of Robert Weinberger Law advises us: “You can’t legislate trust. If you don’t trust the founder, no amount of negotiation or legal drafting of a term sheet is going to be enough, so follow your gut and choose wisely.” (If you are looking for start-up investing council, feel free to contact Claire at claire@rkweinbergerlaw.com.)

Before diving into the below, click here for a quick “angel investing glossary” recap on specific terminology.


What to look for in a preferred equity term sheet

Preferred equity (or preferred stock)  is what you’ll hear us refer to as a “priced round”. This is equity in a company that is issued to investors in exchange for their capital, with certain perks for the investor. Preferred equity is a different class of equity from common stock, which is usually held by founders and employees—the main difference being that investors with preferred stock get paid back first (before the founder and employees) in a liquidity event (such as an IPO or acquisition). Below, we’ve outlined what to look for in a preferred equity term sheet:

  • Valuation: Simply put, the pre-money valuation is what the company is worth today, prior to investment, and the post-money valuation is the pre-money valuation plus the anticipated investment amount. For example, a company with a pre-money of $5M that raises $3M now has a post-money valuation of $8M. The valuation will determine how much equity you, the investor, will hold in the company. To determine this, your check size is divided by the valuation. For example, let’s say you are putting a $50,000 check into a company valued at $5 million post-money. You will own 1% of the company. One thing to note: Be cognizant of how a valuation is benchmarked against other companies in the industry to make sure you are getting a “good deal”. 
  • Anti-Dilution Clauses: Your investment will get smaller over time. Dilution of your equity ownership happens each time a company issues new shares—whether that’s during a subsequent fundraising round or if a company creates an option pool. An anti-dilution clause can mitigate this, but is generally an advanced topic so feel free to skim over this. The two clauses you might come across are weighted average and full ratchet—these are seen as insurance policies for investors to protect themselves against down rounds (i.e. later sales of stock by the company at a lower price than the amount they paid). 
    • Weighted average: Upon conversion to common stock in a liquidity event, instead of an investor receiving the normal one share of common stock for each share of their preferred stock, each share of preferred stock would convert into more shares of common stock. The “weighted-average” determines the adjustment in the conversion rate using a formula based on the dilutive price and the number of shares issued. Weighted-average anti-dilution is more common and generally viewed as more fair than full ratchet anti-dilution, which is seen as punitive to the company and the common shareholders.
    • Full ratchet: Similar to the weighted average, except it only takes into account the dilutive price, triggering a repricing of all the clause-holders’ shares, even if just one new share is priced at a value below the lead investors. These days, a full ratchet is rare and often predatory for an early-stage term sheet; they are seen as an extreme way of applying investor protection because their application can result in investors increasing their ownership percentage once they are triggered.
  • Pro-Rata Rights: For early-stage rounds (Pre-Seed, Seed, Series A), pro-rata rights essentially provide initial investors “first dibs” to invest in a company’s future rounds to maintain their ownership percentage, which would otherwise be diluted. As an investor, having pro-rata rights is a reward for your faith in an early-stage company, putting you at the front of the queue to double-down on your investment and maintain a material percentage of ownership. The down-side: if you’re an investor coming into a Series A deal where there is high demand from other investors to get into the round, pro-rata rights given to previous investors from the Pre-Seed and Seed stage financings can sometimes mean there won’t be enough room for your investment.
  • Right of First Refusal (ROFR): ROFR permits that all current investors, or shareholders, are notified and allowed to buy stock from an investor who wants to sell. 
  • Liquidation Preference: Liquidation preference determines the order in which you’ll get paid back upon a liquidation event such as the sale of a company. Liquidation preferences are  stated in terms of a multiple of the per-share original investment price (i.e. 1x, 2x, etc.). For example, a 1x liquidation preference means that an investor will get 1x their initial investment back. If they put $500,000 into a company and the company sells for $5 million, they will receive their $500,000 back before common stockholders. A 2x preference would raise this hurdle to 2x their investment ($1 million) and so on. This all occurs before common stockholders can begin receiving proceeds. (Ninety nine percent of the time it will be 1x except in the case of a distressed company.) There are two types of preferred stock:
    • Participating preferred: Investors get paid back first from the proceeds of a sale and then share the remaining proceeds with common shareholders based upon ownership percentage in the company.
    • Non-participating preferred: Investors receive their money back first or share the proceeds with common shareholders based on ownership percentage—but not both. 
  • Drag Along Rights: Investors may require common shareholders to vote in favor of a company sale if it is approved by preferred equity shareholders (and often the board). This could have the impact of forcing a sale when it would not otherwise be approved by the founder.
  • Information Rights: This is an important one. This outlines what information the founder must deliver to investors. Generally, this includes regular financial statements, a budget, and might also include access to facilities and personnel. By default, this is usually quarterly, but for early-stage financing, annual is more easily managed.
  • Option Pool: It is common practice for startups to use Employee Stock Option Pools (“ESOPs”) to incentivize and reward employees. We typically see 10% set aside at the seed-stage, but up to 15-25% at Series A as the team starts to scale. Something to note: the post-money valuation is calculated on a fully-diluted basis, which means that any shares reserved under an ESOP will be included in the valuation (including unallocated options). As a result, the valuation in a term sheet will typically include language that specifies the investor’s percentage ownership following this round of financing, including shares reserved for an employee option pool equaling a certain percentage of the company’s equity.
  • Warrants or share options: Very uncommon in early-stage financing, but used as a sweetener to incentivize investors to take the deal. A warrant or option gives the investor the right to purchase a company’s stock at a specific price at a specific date. The biggest difference is that warrants are dilutive and options are not. 
  • Board seats or board observer seats: Lead investors typically request at least one seat on the board of the company. Each time the company raises a new round of capital, the lead investor of that round will seek representation on the board. The second-best option is a board observer seat. It’s rare for an angel investor to take one of these seats unless there is strategic alignment. 

What to look for in a convertible note term sheet

As an investor, the fundamental difference between a convertible note and a preferred equity structure is that the capital you are investing is a form of debt that collects interest and will convert into equity at a later date, usually at the company’s next fundraising round or at an agreed upon “maturity date”. 

  • Valuation cap: Typically, a valuation cap is used for early-stage startups because it is too early to determine a valuation for the company. The cap is the ceiling on the valuation that you, the investor, will convert your convertible note into shares of stock at the lower of either: the valuation cap or the pre-money valuation of the next equity round. For example, if you invested in a company at a $16M valuation cap and its valuation at the subsequent financing is only $12M, your investment will convert into shares at the $12M valuation. Alternatively, if the subsequent financing is a $18M valuation, your investment would convert at the $16M valuation cap.
  • Discount: For an early-stage investor, receiving a discount rewards you for bearing the risk of investing early. A 20 percent discount is par for the course. For example, if you invested in a company at a $12M valuation cap and the subsequent financing is a $10M valuation, your investment will convert into shares at 20 percent off which is an $8M valuation. Alternatively, if the subsequent financing was a $16M valuation, your shares would convert at the $12M valuation cap since it is lower.
  • Interest rate: Generally, no interest payments are ever actually exchanged, but interest accrues and is added to the stock owned when converted at the next round. While a higher interest rate benefits investors, angel investors should still watch out for predatory high rates to ensure the lead investor isn’t taking advantage of the company. In 2021, we see anything from 2 to 4 percent as reasonable. 
  • Conversion mechanics & Qualified Equity Financing threshold (“QEF”): This is important. The specifics of what circumstance your capital will convert into actual equity can be negotiated, but typically, the investment will automatically convert into equity in the form of preferred stock at the company’s next equity financing round. The QEF threshold is the amount of equity financing the company needs to raise in a single round to trigger conversion of your investment. For example, if there is a $3M QEF threshold, a company could raise two subsequent rounds below $3M and your debt would not convert into equity. Typically, we see a $1M threshold as reasonable. A provision can also be added that the note will convert if there is a liquidity event, which is ideal in case there is a sale before the next round of financing.
  • Fully diluted price per share: This is a bit deep in the weeds, but it’s worth asking what the fully-diluted price per share is at conversion. The company’s lawyer should understand which shares are being included to calculate the price per share. As an investor, you want to make sure all convertible notes and outstanding options are included. 

What to look for in a SAFE term sheet

Originally created by Y Combinator as an alternative to convertible notes, the SAFE maintains many of the terms of a convertible note, but it is not considered debt—so it is more founder-friendly. A SAFE does not collect interest or have a maturity date; instead, it defers conversations around these terms to the next round. Use the convertible note section above to get your bearings on a SAFE.


Tax Liabilities 101: How different investment choices affect your taxes

As you think about how your investments will affect your tax situation, it will be important to understand the different ways companies are structured. The tax consequences will depend on which type of entity you invest in. For example, if you invest in a C-corp, the effect on your taxes will be much different than if you invest in an S-corp or an LLC that is taxed as a pass-through entity. In this section, we asked accounting firm Weaver to detail the differences between these types of business structures and the subsequent tax implications. 

C-corporations: For investors, C-corporations have the simplest tax treatment. You as an investor do not have any direct tax consequences until you begin to receive distributions (dividends) from the investment. That is because the corporation pays income taxes as an entity. As a shareholder, you pay taxes when the corporation distributes its profits as dividends. You generally also incur tax on any profit from the sale of the company’s stock. 

  • Qualified Small Business Stock (“QSBS”): Notably for angel investors, a C corporation is the only entity that can issue QSBS. This type of stock, which is intended to encourage investments in start-up companies, offers significant tax advantages. If you hold this stock for at least five years, you will not have to pay federal income tax on some or all of the gains if you sell or exchange qualifying original issue stock. This tax exemption is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the stock. For its stock to qualify for QSBS treatment, you should obtain representations from the company that your investment meets these requirements: 
    • The corporation’s “aggregate gross assets” cannot be more than $50 million before and immediately after the issuance of the stock; and
    • At least 80 percent of the corporation’s assets must be used in a qualifying “active trade or business” during substantially all of the time the investors hold the stock 
    • The corporation cannot have made any significant repurchases of its stock a year before or after the issuance of the stock.

Pass-through entities: Investing in a pass-through entity (partnerships, S corporations or LLCs) will have more complicated tax consequences for you as an angel investor. In most cases, “pass-through” entities do not incur taxes as a company. Instead these entities “pass-through” to each owner their allocable share of income.  The owners then report this “pass-through” income on their tax returns. If you invest in this type of entity, your taxes will be based on the income that you are allocated in a particular year.

This means you may have to pay taxes from your own pocket if the company does not distribute cash to you. As protection, some investors negotiate an agreement to require the entity to distribute cash to pay the tax. If a pass-through entity does business in different states, you may have to pay state income taxes in those states as well. If there is an operating loss, you may be able to apply your proportionate share of the loss to offset other taxable income elsewhere. Limited liability corporations (LLCs) are taxed as pass-through entities unless the owners, known as members, elect otherwise. If you have questions or need assistance with tax planning around your investment strategies, Weaver’s tax partner Rob Nowak welcomes you to contact him at rob.nowak@weaver.com.

With all the information from our legal and tax experts above, you’re ready to sign the term sheet and close the deal. For Module 6, we’ll discuss your post-investment strategy and how to be a good investor.

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