Allens Accelerate

Valuation is often expressed in terms of:

• the pre-money valuation, which is the value of your startup pre-investment; or
• the post-money valuation, which is the value of your startup post-investment (ie the pre-money valuation, plus the intended investment amount).

If an investor wants to invest $1.5 million for 10% of your company, they are essentially referring to the post-money valuation.

In order to work out your startup's pre-money valuation, you need to calculate the post-money valuation, then subtract the investment amount – for example, in a $1.5 million for 10% equity investment scenario, the post-money valuation is $15 million and the pre-money valuation is $13.5 million.

Alternatively, you may already have a pre-money valuation in mind, in which case you can work forwards from there to determine an investors' percentage ownership. For example, you believe your startup is worth $15 million prior to the investment, and your investor is willing to invest $1,000,000 (giving a post-money valuation of $16,000,000) – this means your investor will own 6% following their investment.

Once you have confirmed your valuation, you will need to determine how many shares your investor will receive for their investment. The most common way to do this is to use a capitalisation table (cap table).

In the early days, it can be quite simple to calculate this manually – a share price is calculated by dividing the pre-money valuation by the number of shares currently on issue and you use the share price to determine the total number of shares the investor will receive for their investment. However, it can get complicated as you bring on more shareholders and issue convertible securities (such as options as part of an ESOP). Having a good quality cap table to automatically do the calculations for you will be important.

Investors will typically receive ordinary shares or preference shares. These share classes provide an investor with different rights, including in respect of voting, dividends and entitlement to future sale proceeds.

A company will typically issue ordinary shares to its founders, employees and early investors, whereas most larger investors will opt to receive preferences shares due to the preferential rights that attach to them.

Ordinary shares

Ordinary shares will have:

• Voting rights – the right to vote on all matters put before the shareholders on a one vote per share basis.
• Dividend rights – the right to receive a share of the company's profits via dividends.
• No preferential liquidation rights – if a liquidation event occurs (eg the company is sold or becomes insolvent), ordinary shareholders will receive proceeds after any preference shareholders.

Preference shares

Preference share rights will vary from investment to investment, but will generally include:

• Voting rights – the right to vote like ordinary shareholders.
• Dividend rights – the right to receive a share of the company's profits via dividends – sometimes in priority to dividends paid to other share classes.
• Preferential liquidation rights – if a liquidation event occurs, the right to receive a priority payment ahead of other shareholders. Generally, this amount is the greater of:
  

  (1) the amount they invested into the startup (or in some cases, a multiple of that amount); and

  (2) the amount they would receive if they converted their shares into ordinary shares.

  The liquidation preference is one of the primary motivators for investors requesting that startups issue preference shares, as opposed to ordinary shares. The 'greater of' formulation helps the investor safeguard their investment but also receive more than their investment back, should the liquidity event occur at a higher valuation than when they invested.
  
  If there are not enough sale proceeds to pay all preference shareholders their investment amount back, generally the proceeds are distributed to the preference shareholders pro rata. If the company has multiple classes of preference shares on issue, there may also be a 'liquidity waterfall' which sets out which preference shares are paid out ahead of others.
• Anti-dilution protections – an entitlement to have their shareholding adjusted if a company issues new shares at a lower valuation in the future – ie a 'down round'. This adjustment is most commonly based on a weighted average of the relevant share prices across the two rounds – which softens the dilutive effect for the investor but doesn't remove it altogether. However, a more investor-friendly approach which we occasionally see is for the adjustment to be 'full-ratchet' which adjusts the investor's share price to the share price of the new round (making it as if they invested at this valuation all along).
• Conversion rights – the right to convert preference shares into ordinary shares at any time, as well as automatic conversion on certain triggers for example, an IPO (ie a company going public).

Your startup's constitution will set out the rights attaching to each share class.

When introducing multiple classes of preference shares, try to ensure as much consistency as possible across the terms. This will make it easier for you when the time comes to sell your company or IPO.

The term sheet will generally detail how the board of directors will be constituted following the investment.

Typically, major investors (ie a 'lead' investor) will want a right to appoint a director to the board (or at a minimum, a board observer). This is negotiated on a case-by-case basis, depending on the nature of the investment, composition of the existing board and the parties expectations of ongoing control and governance.

Founders will also want to entrench their rights to appoint directors, to protect their control over the startup.

Your constitution and shareholders' agreement should set out the powers and structure of the board. It is important to understand the power and influence that your new investors have over the board.

In any company, key decisions are typically made by either the shareholders or the board of directors.

It is important to agree upfront the manner in which decisions about the business of your startup are to be made – this includes who should make the decision and any other conditions to be satisfied or consents required in order for that decision to be effective.

Generally, decisions regarding the day-to-day operation of the startup are made by the board (with standard matters determined by a simple majority, and important matters often requiring a higher decision making threshold). The board may also delegate its decision making powers for the more mundane matters to key management personnel. However, critical matters relating to the future of the startup are often reserved for the shareholders.

Board reserved matters

Decisions such as adopting or changing the startup's business plan, taking on significant debt, entering into valuable contracts or raising capital often require a special majority of the directors to agree (eg 75%) and may also require specific director consent (eg the consent of the founder director and/or investor director).

Shareholder reserved matters

Decisions such as materially changing the nature of the business, determining director remuneration or deciding to wind up or sell the company often require shareholder consent (usually by way of a special resolution – requiring shareholders who hold 75% of the votes to agree). It is possible to require a specific shareholder's consent for these matters (eg the consent of the founder or a major investor).

It is common for shareholders to be provided with a first right to purchase up to their pro rata shareholding of any further share issuances by the company (ie participate in your next capital raising to maintain their percentage ownership in the company).

Shareholders will also generally have a right of first refusal on any shares sold by existing shareholders - so a shareholder who proposes to sell their shares to a third party must first offer them to the existing shareholders (who can generally take up their pro rata share). 

• Tag rights: shareholders often have tag along rights with respect to a sale by another shareholder(s) of their shares, where that sale will result in the buyer holding a certain percentage of the company (commonly >50%). This means that a sale of shares will be permitted only if the buyer also acquires (on the same terms) the same proportion of shares of the shareholder exercising its tag-along rights.
• Drag rights: shareholders may be subject to 'drag-along' rights if shareholders holding a designated majority % of the shares in the startup (of any class) wish to sell their shares to a third party. This means the selling shareholders may require that all other shareholders sell their shares to a buyer on the same terms (essentially, 'dragging' them along with the sale).

Tag and drag rights are common in investor-backed startups. In particular, drag along rights are often hotly negotiated, as the right to exercise a 'drag along' is akin to a right to approve the sale of the company's shares. 

Warranties are statements of fact made by the company (and possibly the founders) to the investor at the time of their investment. The company (and founder, if applicable) will be liable to the investor if these statements are untrue. Startups should resist providing founder warranties where possible. If these are required by an investor, the scope of these warranties, and the founders liability exposure, should be closely considered.

Following the execution of the term sheet, the startup will provide investors with information, access and support reasonably required for the purposes of conducting financial and legal due diligence.

The investor is generally under no obligation to continue with its due diligence or investigation or to complete a transaction, if at any time, the results from due diligence are not satisfactory to the investor for any reason.

You can find out more about the due diligence process in our Preparing for Investment article.

The following transaction documents are generally contemplated on customary terms to evidence a transaction (including to reflect the details set out in this Term Sheet):

• Subscription Agreement; and
• Shareholder's agreement.

A term sheet is generally non-binding, other than specific clauses (for example, the confidentiality clause). It is intended to be a statement of intent only in relation to an anticipated agreement between the startup, the existing shareholders of the startup and a prospective investor.

However, it is not wise for parties to attempt to deviate from the terms of the term sheet when negotiating the definitive agreements. If a party is looking to stray from the agreed term sheet, this can derail the negotiation (and potentially kill the deal altogether). It is therefore very important that startups understand and are comfortable with the terms of the term sheet, before signing.