Understanding a Term Sheet’s Impact on "Real" Valuation

You think you just negotiated a fair deal or maybe even a sweetheart deal with an institutional investor because you got the price per share you wanted. Sophisticated angel and venture capital investors may agree to accept the valuation you specify or at least negotiate one that is palatable to you, but it may not be as great as you think. In the financial industry the value stated on a term sheet or investment agreement is referred to as the “stated value.” This is rarely the “real value” or the value after all factors are considered.




There are a number of provisions in the typical term sheet that alter the value stated as a per share price. Some may reduce the real value by 50% or more! Let’s take a look at provisions found in most term sheets. First of all the institutional investor will ask for “participating preferred shares.” This is a far cry from the common shares the founders and their family and friends own. The “preferred” means that if the company is sold or wound up in any other way, say liquidation or bankruptcy, the preferred shareholder gets its money out before any common shareholder receives a payout.



The “participating” means that after the preferred shareholders receive their original amount back, they split the remainder on a pro rata ownership basis with the common shareholders. To make this even more dilutive to the common shareholders, the amount the preferred shareholders receive before any other money is distributed is many times a multiple of their original investment. For instance, it is not uncommon for the “liquidation preference” to 150%-200% of the original investment. During the recent recession there have been instances of it being even higher!



Another feature of preferred stock is that it typically carries a dividend. The dividend rate is dependent upon the current credit market but it is not unusual for it to be 7%-8% annually. Usually in venture deals the dividend is deferred until the company is sold, merged, wound up or goes public but must be paid prior to any money going to common shareholders. If you add this to the liquidation preference, the investor could be receiving two to three times their investment back before the common shareholders share the remainder with them. This is no big deal if the company goes public for 10-20 times the original value but if it is just modestly successful it can leave the common shareholders with little or nothing!



In some deals there may also be warrants issued to the investor either for doing certain things for the company or if the company does not meet certain conditions. These warrants may be converted to stock well below the market value of the stock lowering the value of the common stock even more.



Finally, there are usually anti-dilution provisions, usually in the form of “ratchets,” that require the company issue additional shares in the event that stock is subsequently sold at a lower price than the price paid by the original institutional investor. A “full ratchet” basis requires enough stock be issued to bring the value up to that of the new investor. A weighted ratchet basis makes up some of the value lost.



There are other provisions that might indirectly affect the value, as well such as board representation and pre-approval provisions for such things as borrowing and purchasing of certain items. None of this is hidden, illegal or unethical. After all, the venture investor is taking a risk that no one else is willing to take.



It is also a way for the investor to protect their downside and many times used to come to agreement on a difference in valuation. They might pose it to the company in this way: “We are not confident that you can meet your projections and if you do not, the value of the company will certainly be lower but we are willing to accept your valuation if you will allow us to protect ourselves from under performance. If in fact, you truly believe in your valuation you shouldn’t mind these provisions. They will not affect your return significantly if you perform.”



The problem comes when the entrepreneur does not understand the impact of the provisions or is too optimistic about company performance. Much of it is also emotional or psychological. Perhaps your friend’s or your competitor’s company was just valued at $5 million and you are sure yours is worth just as much, or maybe you have calculated how much you need to retire comfortably. In any case, if stated value comes out where you wish you can rationalize it as a fair deal.



It is always a good idea to have a professional that is experienced in valuations and term sheet evaluation look over the offer - Help you understand what it means and how much the company needs to sell for in order for you to get a satisfactory return. Finally, an attorney experienced in securities law should always review the legal aspects of the term sheet or offer before you sign. Venture capitalists and their attorneys deal with term sheets routinely but it may be the only one you ever see!