Terms in Term Sheet Series 2: Liquidation Preference

Posted on November 3, 2011 by Chris Allo

This is the second round to cover up the terms in term sheet. The main subject is about liquidation preference, which is concerned with the division of the value when liquidity event – the sale of the company or the majority of the assets – occurs. Notice that liquidation preference is not about control, but utterly about money. It consists of two parts – the actual preference and participation.

Actual Preference

The actual preference is specified with the number which is the multiple of the original investment per share to be returned to investors in preference to the common stock holders. For example, if a series A investor invests $10m with 2x preference, then he will receive $20m in return when the company is sold. Occasionally the number goes higher than 1x, but in most case it is set to 1x.

Participation

Participation is another significant term in liquidation preference. It determines how the money shall be divided and delivered to investors. There are three options in participation.

  • Non-participating: It is easy to calculate. In non-participating, the investor gets the pro rata amount of investment. For example, if the sale price is $100m and the investor has 40% of equity with $20m of original price, then the investor will get $40m, or 40% of $100m.
  • Participating: Participating increases complexity on the event, yet the concept is simple. The investor may get the original investment price first, and then do calculation with the rest of the money. In the above example, in participating, the investor takes $20m – the original invement price – first and takes 40% of the rest of money, which is $32m or 40% of $80m. So the investor takes $52m in total.
  • Participating with cap: Capped participation is a condition statement which indicates that a certain multiple return shall be reached. When the preferred doesn’t reach the cap, the fully participation is applied. See the example again, assuming that the contract is in participating with a 3x cap. As the return ($40m) doesn’t reach the cap ($20m x 3 or $60m), the result would be the same as the participating case. If the purchase price goes up to $200m that it makes better than 3x, the participation doesn’t happen.

Participation makes the deal more complicated because the other fundraising may follow up inevitably. Thus, it’s always better to simplify the liquidation preference especially in early days of business. That is, the entrepreneurs should choose the non-participating option for the future deal.

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Terms in Term Sheet Series 1: Price and Option Pool

Posted on October 24, 2011 by Chris Allo

Term sheet is the primary sentences for the start-ups as they need money from investors. And not to be confused or sneaked by VCs(venture capitalists), the entrepreneurs should keep the terms fully understood. So I share the description of the terms in a series so that the beginners can get the overall terms of term sheet. Today, we’ll see the price and option pool.

Price

Price is the very basic unit of the deal as it is a measure of the valuation of the company. To get into the notion, we need to understand the terms ‘premoney’ and ‘postmoney’ because the investors’ mentioning the valuation would determine the actual value of the company. Premoney, usually called  ’pre’ in short, is the valuation before the investment whereas the postmoney is the valuation including the investment amount.

Let’s see an example. If a VC says, “I will invest $5m at a valuation of $20m,” it usually means the postmoney valuation. As a result, the investor will get 25% of equity – $5m portion of $20m. On the contrary, when the VC clarifies the valuation as premoney, then the VC gets 20% – $5m of total $25m postmoney. So do the math before talking about the price.

Option Pool

There’s one more thing to consider: option pool. Option pool is the equity reserved to compensate the employees, so it is also called as the employee pool. It is important because the entrepreneurs’ share would decrease relative to the increment of the option pool. In the above example of postmoney valuation, suppose that the entrepreneur sets the option pool to 10%. Then what if the VC requests to scale it up to 20%? The VC’s portion doesn’t change though, the founder would hold reduced portion of share, which is 65%, 10% less than the original portion if the request is accepted. Thus, the option pool should be considered if the VC tries to touch this.

There are many other economic terms like liquidation preference, warrants, pay-to-play, vesting and antidliution in term sheet. I will compact the description of the terms into the summary as if I posted here today. Next time we’ll see the term, liquidation preference.

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The Concept of Social Data Service (SDS)

Posted on August 14, 2011 by Chris Allo

Cloud is hot. I’ve been prepared cloud-based database system which aims to make a business of so called Social Data Service (SDS). It comes from very basic concept that key-value pairs can be linked to each other. Furthermore, it extends the scope of linkage to the other business. It accelerates the business partnership easier than ever. The data model looks like the follow.

For example, it’s possible that a game company who uses this database model can link game data to other records in online shopping mall database. The main idea has been applied to the patent, and now I participate in the development of the project which name is Cloudbean. The patent involves the content about domain rule and domain access control as well as the linked record pair stuff. In reality, the system may serve the link attributes as well.

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