1. Offering Terms

The first main element of the term sheet usually contains the Offering Terms. These terms generally include information about the following issues:

  • Issuer
  • Investors
  • Current Securities Outstanding
  • Amount Raised
  • Type of Securities
  • Price Per Share
  • Pre-Money Valuation
  • Capitalization Table

Let us have a look at an example of such offering terms:

 

Issuer Firm X ("Company")
Investors VC Fund Y ("Investors")
Current Outstanding 5'000'000 of Common Stock ("Common"). In addition, by closing, the Company will have reserved for issuance under its stock option plan an aggregate of 3'000'000 shares of Common ("Reserved Shares"), of which 1,234,567 are subject to previously granted options.
Amount of Investment $6'000'000
Type of Securities Series A Convertible Preferred Stock ("Series A Preferred" or "Preferred")
Number of Shares 6'000'000 shares of Series A Preferred
Price per Share $1.00 per share of Series A Preferred ("Original Purchase Price")
Pre-Money Valuation $8'000'000

 

Note that some of the information is redundant in the above table, which is why some term sheets do not show it explicitly.

For example, the table shows the amount of investment, the number of shares, as well as the price per share. Clearly, these three elements are related as follows:

 

Amount of Investment = Number of Shares × Price per Share.

  

Therefore, it would be sufficient to list only two of the three items.

  

Similarly, the information about the pre-money valuation is, in principle redundant. The term sheet indicates the price per share, the amount of investment, as well as the total number of shares outstanding (on a fully diluted bases). With this information, we can back out the pre-money valuation:

  • On a fully diluted basis, there will be a total of 14 million shares outstanding
    • 5 million shares of common stock that are currently outstanding
    • 3 million shares of common stock from the option plan (Reserved Shares)
    • 6 million shares of Series A Preferred.
  • At a price per share of $1.00, and assuming that 1 share of Common Stock has the same value as 1 share of Series A, this implies a post-money valuation of $14 million.
  • Given an investment of $6 million, the pre-money valuation is, therefore, 8 million.

 

It is important to note, however that this assessment of the company valuation only works if the price of a share of Common stock equals the price of a share of Preferred Stock. Given that the two securities have strikingly different payoffs (see previous course section), this is typically not the case. The implication is that the above back-of-the-envelope calculations, which are often used in reality, rarely produce a very meaningful "valuation." We will get back to this important issue at the end of this course section, when we discuss the difference between value and price.

 

Offerings with Performance Hurdles

Note that offering terms sometimes include performance hurdles. Such a performance hurdle could be used in cases where there is a lot of uncertainty (or disagreement) about how quickly the firm's product will make it to market. For example, the terms could stipulate that the firm has to reach annual revenues of, say, $3 million during the next fiscal year. If the firm fails to reach this hurdle, additional shares will be issued to the investor, with the effect that the overall issue price will be lowered for the investor.

To make sure that the firm will actually have the necessary additional shares to issue to the investor if needed, the term sheet generally stipulates that these shares be held in escrow.

To see how such performance hurdles work, let us go back to the above example with a slight modification (modifications in red).

 

Issuer Firm X ("Company")
Investors VC Fund Y ("Investors")
Current Outstanding 5'000'000 of Common Stock ("Common"). In addition, by closing, the Company will have reserved for issuance under its stock option plan an aggregate of 3'000'000 shares of Common ("Reserved Shares"), of which 1,234,567 are subject to previously granted options.
Amount of Investment $6'000'000
Type of Securities Series A Convertible Preferred Stock ("Series A Preferred" or "Preferred") and Escrowed Shares (see below)
Number of Shares 6'000'000 shares of Series A Preferred

Escrowed Shares

In addition to the 6'000'000 shares of Series A Convertible Preferred Stock, 666'667 shares of Series A Preferred are to be held in escrow and not issued unless the Company has not achieved fiscal year XXXX revenues of $3'000'000 (“Escrowed Shares”)

Price per Share $1.00 per share of Series A Preferred ("Original Purchase Price") if the Escrowed Shares remain in escrow. If the Escrow Shares are released to the investor, the Price per Share will be $0.90.
Pre-Money Valuation $8'000'000 (assuming no issuance of Escrowed Shares)

 

If the firm meets the performance hurdle of revenues of $3 million, the terms of the offering are the same as the ones discussed above. In contrast, if the firm fails to reach this hurdle, the following happens:

  • The 666'667 shares held in escrow will be released to the investor
  • Consequently, the investor will hold 6'666'667 shares of Series A Preferred
  • Given an investment of $6 million, the weighted average issue price drops to $0.90 [= 6'000'000\6'666'667).
  • There will be a total of 14'666'667 shares outstanding
    • 5'000'000 shares of common stock that are currently outstanding
    • 3'000'000 shares of common stock from the option plan (Reserved Shares)
    • 6'666'667 shares of Series A Preferred.
  • The post-money valuation of the firm will, therefore, drop to 14'666'667 × 0.9 = 13.2 million
  • Consequently, the pre-money valuation will be 13.2 - 6.0 = 7.2 million.

 

Now that we have seen how to interpret the main elements of the Offering Terms, let us take a closer look at how to value (or design) the specific financing instruments.