One of the great privileges of working within a deep tech VC fund, is the opportunity to find within Universities and research institutes, cutting edge scientific research that, if moulded and matured a little, could potentially revolutionise a given industry or create new ones. 

Much has been written about how Australia isn’t yet optimising the translation of research into commercial outcomes. And there have been many fingers pointed, very much like the spiderman meme, about why that is. 

My personal view is there is shared responsibility to be laid at the feet of all stakeholders within the ecosystem, including investors like us. Which is why we have spent the past few years trying to understand the various friction points, and find ways in which we can grease the wheels over them. One of these initiatives is to build a library of resources including blogs like this to help demistify the process. 

This piece is focussed on the fundamentals of equity financing when thinking about starting up or spinning out a company. If you are looking for a deeper dive on some of the points this piece raises, I’ve written before about the ANU experiment in establishing a standardised framework for Startups to help streamline the commercialisation and translation of research. I’ve also written about some of the downstream consequences founders and stakeholders need to think about when structuring their very first financings to ensure they don’t shoot themselves in the foot. 

But first lets start with the basics.

Standard terms that occupy most of the focus

As a VC I’m loathe to build a better mousetrap, so in the spirit of efficiency I will point you to these great explainers that Airtree put together which not only provides an open source term sheet for different types of investment, but also explains in plain language standard terms and what they mean. 

However, like most things. in my experience, about 20% of these terms or buckets of terms take up about 80% of emotional energy and time in the negotiation process. Some for good reason, while there are a few terms which almost never get discussed as much as they should.

Lets start with what usually occupies the majority of concerns for founders and foundational shareholders:

Valuation

• Price - Understandably, this is essentially the price of the equity you are selling to an investor, and so is a headline issue for most founders or research organisations. But this is often looked at through a very one dimensional lens - what is the maximum price i can get today, which will minimise the amount of equity I need to sell.  In this way it’s very much a transactional lens reduced to dollars. However, there are other dimensions that should be considered if one wants to ensure that the headline valuation is not setting the company up for failure. 

• Dilution -  For example, consider how much capital do you need to raise now to achieve a key value inflection milestone, and what will the dilutionary effect be to the existing shareholders. If the existing shareholders are active or operational in the business, and are needed to create further value in the business, will their equity holding post financing be significant enough that they will remain incentivised and can be aligned with the incoming investor? While an investor may be able to acquire 80% of a company for the capital they invest, if the founders are needed to continue to work in the business, then there is a misalignment of incentives. Likewise, if the company wants their investors to be active, and to play a significant role in future financings, exchanging too little equity for their capital may risk the investor unmotivated where they have a portfolio of 20 + companies to devote their time and resources to and will likely spend more time where they will see a ROI that will move the dial for their fund returns. Its also worth stating, that you want to build your capitalisation table such that at your next round, your existing investors will have sufficient equity that you can cornerstone that next round with insiders. I parse this out more in this previous blog.

• Capital Intensity - how much more capital needs to be raised in future rounds. An example is to think about why you see Trillion dollar valuations for companies like OpenAI. It’s not because they are intrinsically worth trillions of dollars, but rather a function of the fact that they have to raise Billions of capital to build the infrastructure and compute power required to power the LLM that underpin ChatGPT. Good capital management means the second order consideration you need to build into your thinking is the amount of capital the company will need over its lifetime, and broadly how to break them down into bite sized pieces that will achieve value increasing milestones align the way to minimise dilution. There is no point raising your first round at a $2M valuation if the company needs $10 m in the first round to reach a value inflection milestone, and needs to raise $250m to get to market. You need to start at a higher valuation to ensure that the likely dilution at each round won’t flood out the key starting shareholders and founder.

Ultimately the valuation is a function of all of the above, and neither one is sufficient. 

Control over Decision Making

The key groups who get to make decisions about the company are the Board, and the shareholders, and the types of decisions that are made by each are usually outlined in the company’s shareholders agreement. Usually the Board are tasked with decisions relating to governance and strategic direction of the company. Shareholders, as owners of the company, however are often required to vote on issues that go to the heart of the economic rights attached to preference shares, such asa change of control or an IPO. 

The key terms to be aware of in any equity transaction are:

• Decision Thresholds - What are the thresholds of shareholder approval needed to effect a decision. Will this cause operational difficulties in reaching decisions quickly because there are multiple shareholders? Can small shareholders effectively block a key decision that will be important for the future and success of a company?  It’s also important to think about how this may evolve over time as a company raises more capital. 

• Preference Share Rights - Usually, investors will seek to give preferential shareholder rights for certain subjects to financial investors (over ordinary shareholders),. If so, what are the thresholds to reach a decision. Some decisions will require 70% of preference shareholders to agree before it can be passed.  This will mean that your new investors in any round will have to agree in the majority that a particular action makes sense.

• Board rights - Does the investment enable the investor to have a Board role? If so, what are the relative thresholds needed for a Board to make decisions (simple majority?) - do the investors or any one shareholder group get veto rights over any decisions at the Board level? Veto rights are quite customary and understandable for an investors if they are taking the majority of the capital risk for critical business decisions (like raising new equity), however it is worth understanding their impact.

It’s common for founders and foundational shareholders to be wary of giving up ‘control’ when bringing on investors. However, it’s a necessary part of the equity raising process as these investors have a duty to their investors to be great custodians of capital. This means they have to be able to exercise some control over key decisions of the investments they make. This control will often reduce over time and as the company matures. However in the earliest stages it is a necessary trade off that founders need to be comofortable with before they progress down the equity financing road.

Founder Vesting

Most institutional investors will seek that founders submit their equity to a vesting schedule. To be very clear this means that the equity they will hold after the financing is completed will be at risk, but vests back to them over a period of time.  Typically, the “reverse vesting” model is used, meaning that founders hold all of their shares (this is important for shareholder voting purposes), but may be forced to dispose of their unvested shares if they leave the company before the end of the vesting period.  Most investors will look for a four year linear vest, with a one year “cliff”.  This means that 25% of the founders shares vest one year, and the remaining 75% vest over the next three years.  In some circumstances, if a founder is a “bad leaver”, their vested equity may be at risk.  What is a “good leaver” and “bad leaver” varies from investor to investor. 

The reason investors look to vesting is because it recognises the crucial role that founders play in early stage companies,, aligned with the investors to continue to contribute to building value in the business. There have been occasions when investors make an investment, only for the key founder to depart the company shortly after leaving the company (and the investors) with a company that can’t execute on its plan. The equity that they would forgo by departing the company earlier than the four year vesting schedule may then be used by the company to incentivise and attract a new CEO, CSO or whatever role the founder was playing in the business.  

While customary, this term can seem punitive to some founders who believe their equity has already been earned through the effort and contribution made since the company was established. And this is why it represents a large proportion of the negotiation process. However, it is designed to ensure that all parties are wearing some risk in the value of their equity, and pulling in the same direction.  There is variance in  the proportion of equity that vests, the timeframe that it vests over, what is a ‘bad leaver”, and what the buy back price for a bad leavers equity is.  

Terms which you should pay attention to but often get ignored.

Liquidation preferences - liquidation preferences enable a shareholder to have their capital returned, in the event of an exit or liquidation event, ahead of other shareholders who hold a junior class of shares. Sometimes investors will ask for a multiple of their capital to be returned before other shareholders see any return. Prima facie, there is nothing wrong with liquidation preferences and they are commonly used, but what stakeholders need to be cognisant of is the liquidation preference stack that builds up over time as serial financings are completed. If a company raised a $10M series A, a $30 m Series B, and a $100M series C, and each investor group receives a 1 x liquidation preference, then this means that $140m of capital will need to be returned to those investors, before the other investors see a dollar. Even if other shareholders hold more equity than any of the series A, B, or C investors. And so, if a company sells for $150m, then the rest of the investors will only see a proportion of the remaining $10m. This is a designed as a protection for investors in a low sale value scenario, to ensure that at least their capital is returned. The issue arises when there are 2 or 3x liquidation preferences, which can also mean that ordinary shareholders may lose out even when there is a mid to high sale outcome. Founders and other shareholders just have to be mindful of what the value of the liquidation stack is at any given time, to understand the impact on other shareholders.

Multiple SAFE notes - SAFE notes are a wonderful structure that enables companies to raise money quickly, and without undue burden. And on the face of it, it seems like offering investors the ability to convert the debt into equity at a discount to the next main financing price is reasonable. What we sometimes see is companies constantly raising money by multiple SAFE notes before a priced round, and the quantum of capital raised becomes an enormous burden on a future cap table. A real life example we saw recently was a company with over $20M of SAFE notes that were to convert at a 30% discount to the priced round. The company wanted to raise $20M in a priced round, but the market valuation for the company was, by our estimation no more than $20M. This means that if they were successful in raising the round, it would mean the $20M of SAFE notes would covert at a valuation of $14m (30% discount)…diluting existing shareholders by 60%, and then the additional $20M, would further dilute the shareholders further again. This was unacceptable to the company, but what this did was essentially render the company unable to raise capital. By not converting the SAFE notes along the way by raising priced equity rounds, the company was gambling on the hope that it would raise money at a high enough valuation to absorb all the notes. Leaving them with a toxic cap table structure that rendered them impotent. Used sparingly, or in a limited way, SAFE notes are an excellent tool, but they should be converted in a timely basis, to ensure the company can manage its cap table in real time.

ESOP - ESOP is the most valuable lever you hold to incentivise the company’s employees and advisers. Usually a company will have a threshold for how much equity can be set aside for an ESOP program such as 10% of 15%. when the ESOP pool is created or refreshed also matters when considering a term sheet. Is the ESOP pool to be set aside PRIOR to the new capital being invested, or after? The dilutionary effect may substantially impact existing shareholders and so needs to be considered as part of the term sheet as a whole.  It is also worth noting, if the threshold for ESOP in a constitution or shareholders agreement is 15%, it doesn’t mean the company has to establish a 15% pool, it means that it has the capacity to set aside a 15% pool of ESOP. We have seen companies that have been hamstrung by a threshold for ESOP that is too low, because they need a larger pool of ESOP to reward their team.

It’s also worth noting, that when employees/founders hold more than 10% of the shares of an early stage company, they no longer qualify for the ESS tax deferral. More information can be found here about the impacts of shareholding on tax outcomes here but this can be a significant impact for the employee so tax advice should be part of your consideration.

The TL:DR

Term sheets can seem complex, and overwhelming. All the terms are intertwined and so reducing the areas of focus to high level issues like Valuation can often lead to difficult issues that can’t be undone later.  The best way to confront this is to make sure you are getting advice from a commercial lawyer who routinely deals with startups right from the beginning, but also take the time you need to understand what the various terms are and their downstream effects. There are plenty of valuable resources available now to help bring you up to speed quickly, and good investors will take the time to walk you through it.