1. Introduction

The purpose of this section is to discuss the most frequently used tools and instruments to allocate the financial returns of a venture between the entrepreneur and the investor. The resulting deal structures serve the following three general purposes:

  • Bridge valuation gaps
  • Provide high-powered incentives to work hard
  • Screen out less confident entrepreneurs

In the section on Staged Capital Contributions, we have seen how to work towards the same three goals by splitting an investment into multiple rounds of financing that are tied to major milestones in the development of the firm. In this session, we look at financial deals that allow us to distribute the returns within a given round of financing. The resulting deal elements represent an important element of the so-called term sheet. For an excellent template of such a term sheet, see here.

  

We have argued in the previous section that investors might often be confronted with the following two concerns:

  • Entrepreneurs are generally more optimistic about their venture than all other people, in particular investors
  • Moreover, once the capital is paid in, there is not much that (non-controlling) investors can do to affect the fate of the company.

To address these concerns and avoid "take the money and run," VCs generally ask for preferred returns and, more importantly, liquidation preference. With the resulting deal structures, they make sure to receive their money back before the entrepreneurs get their return. The typical financial instrument that is used for such deal structures is Preferred Stock. 

 

In the following subsections, we look at the logic behind preferred returns and how to implement preferred stock financing in a term sheet. The following three key elements are to be considered:

  • Dividend payments
  • Participation and liquidation preference
  • Redemption rights.

 

A common financing policy for new ventures is to start out with Common Equity that is contributed by the founders, family members, friends, and "fools." For subsequent rounds of financing that involve professional investors, these firms then issue  new series of Preferred Stock. So Series A Preferred Stock is issued to investors in the first round of financing, Series B Preferred Stock goes to investors in the second round, etc. 

This is also the financing sequence that we will have in mind when discussing deal terms. Put differently, we will assume that the common stock of the firm is owned by the founders (and the three other Fs) and that the financial investors then buy shares of Preferred Stock. 

For your convenience, we have also compiled an online tool called Term Sheet Wizard that allows you to quickly assess how the important deal terms that we discuss in this section affect the allocation of value and control between the founders and the investors.