Term Sheet Math — When Is Your 66 Percent Really 52 Percent?

by Foley & Lardner LLP
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When negotiating valuation for a financing, an investor may conduct detailed due diligence and present you with a term sheet that reflects multiples, discounts, comparables, and so forth. In the end, you are negotiating for percentage — how much of the company will the investor get, and how much will you keep? Your investor is focused on maximizing return on investment. You are focused on keeping meaningful upside for your innovation and hard work.

For example, if you raise $5 million on a $10 million pre-money valuation, you will be giving the investor 33 percent of your company. You keep 66 percent. But that 66 percent may not be really be 66 percent even before you take into account any later dilution by subsequent rounds of investors. There are at least three reasons why.

First, investors often invest on a “fully diluted basis,” which includes an assumption that an unused stock option pool is actually issued and outstanding. The theory is that you will need to issue options to incentivize your employees to achieve the growth reflected in your business plan, and that you received a valuation based on your entire business plan. The result: Only you are diluted by the option pool.

Based on the example above, if the investor requires that a 10 percent stock option pool be included in the calculation of shares on a fully diluted basis, then the investor gets 33 percent, the option pool is 10 percent, and you keep 56 percent. Of course, the result is not as bad if the full option pool is not used prior to an exit event, but many option pools are completely used, and often increased, prior to an exit event.

Second, investors often receive a liquidation preference upon a sale of the company — in other words, a return of capital before anyone else gets paid. If the investor also requires a “participation” feature, then the investor receives a return of capital, and then participates with respect to the balance of the sale on an as-converted basis. The result: The investor receives a percentage of deal proceeds that is higher than the investor’s percentage of shares.

Based on the example above, assume a sale with $100 million in proceeds. If the investor has a liquidation preference with a participation feature, then the investor receives $5 million as a return of capital, and then another $31.35 million (33 percent of $95 million). The option pool participants receive $9.5 million (10 percent of $95 million). You receive $53.2 million (56 percent of $95 million). The result: You receive 53.2 percent of the proceeds. This shift in percentage gets worse for you if there are less deal proceeds, and better if there are more.

Third, investors often receive payment of accrued dividends on an exit event, and the dividends can add up. Dividends on $5 million accruing at eight percent, compounded annually, amounts to another $2.3 million after five years. The result, re-running the math based on the example above: You receive 51.91 percent of the deal proceeds.

When negotiating percentages, we caution against being too focused on incremental percentage points. With the right investment, you can end up with a slightly smaller slice of a much bigger pie. However, it’s important to understand all aspects of dilution so that you know, in the beginning, what you are really bargaining for.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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