Equity financing has only recently become a viable option for companies in the cannabis industry. As a result, many industry entrepreneurs are unfamiliar with equity financing terms. Also, many entrepreneurs (in many industries) don’t dig deeply into terms they don’t understand, which is a dangerous game. For example, trying to read the National Venture Capital Association Model Term Sheet–all 16 pages of it–is not helpful for someone starting from scratch, because the document assumes knowledge of its terms, and no matter how many times you read “liquidation preference” on a term sheet, the meaning will not become clear.
Asking your attorney to walk you through the terms you don’t fully understand can be helpful, particularly so she doesn’t assume that you understand things that you don’t, and which are about to affect your pocketbook. It’s also a great way to vet your attorneys’ understanding of the terms. However, reviewing with your attorney is unlikely to be a comprehensive education; or, if it is, will be an unnecessarily expensive education.
In the end, the undeniable truth is: If you’re an entrepreneur who is serious about raising funds through an equity financing, then you owe it to yourself, your company, your investors and shareholders, to educate yourself. In business, “depending on the kindness of strangers” is not a viable strategy. If Tennessee Williams wrote “A Startup Named Desire”, it would certainly be a tragedy. There are many resources for your self-education, but top of my list for recommended reading is “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist” by Brad Feld and Jason Mendelson.)
Until you complete your education, below is a primer on five equity financing terms that you must understand before you ever sit down with an investor to write a term sheet. I’ve gone with top five because these are the terms that are most critical, most likely to be negotiated, and the ones you need to understand to get the core of the financing right for your business. Of course, this list is by no means exhaustive.
1 – Valuation
Valuation is always the most critical term of an equity financing: it’s how much of the company you are selling, in exchange for how many dollars. Valuations are straightforward with the exception of two aspects that perplex entrepreneurs:
- There is no one-size-fits-all science to the process of arriving at a valuation. It is a negotiation between the company and the investor. There are models, there are metrics, there are comps, there are hopes, dreams, and business plans, but ten investors could look at a company and arrive at ten different numbers. Cannabis business valuations are especially unique, as we have covered here and here.
- Valuations are expressed as the value of the company before the investment round (the “pre-money valuation”) and the amount it will be worth after the investment round is completed, accounting for the “new money” the company has received (the “post-money valuation”). The confusing aspect of this is that this can be expressed in any order, and not necessarily using “pre-money” and “post-money” (which are almost always shortened to “pre-” and “post-” because syllables = time = money, right?). Often the expression will be stated as a total dollar figure based on pre-money valuation (“I’ll put in two million, based on eight pre-“), or as a a percentage using the post-money valuation (“I’ll put in two million to own 20% post.”)
- And one more, which I get often: Remember that you are not selling a set-in-stone percentage of your company. You are selling shares, a.k.a. stock. An expression of a percentage will determine the number of shares of stock to be sold (which will be newly-issued “Preferred Stock”) and the purchase price of the shares, based on the number of shares currently outstanding. But you don’t get to 100% and run out of equity–more shares will be issued in the next financing, the number of shares will increase over time, and percentages will change. Expanding the size of the pie is the focus, rather than the size of each slice.
2 – Liquidation Preference
A liquidation preference is an investor right that is triggered when the company is sold, merged, or otherwise liquidated, and it allows the investors, who are holding preferred stock, to be paid (and sometimes paid multiple times over) for their stock before the common holders receive anything. In theory, this can result in preferred stock getting a large portion of a sale, or even theoretically all of the sale (although the company is unlikely to pursue such an acquisition, if the price was only sufficient to cover the preferred shareholders’ liquidation preference). A liquidation preference may seem unfair if you equate the sweat equity of the founders and employees who built the company with the investors’ dollars that funded it. But, the liquidation preference is central to why VCs invest: Any acquisition, even a modest one, will be favorable for the investor, and offset all of the other, inevitable company failures in the investor’s portfolio. Company founders are unlikely to remove a liquidation preference entirely, but should be able to keep it at 1x or 2x at most. Liquidation preferences of 2.5x or greater are only appropriate in the riskiest, moonshot-style deals.
3 – Participating Preferred
Participating Preferred is another “pot” sweetener for the investor that is triggered upon a sale (must ensure that rate of return doesn’t disappoint the fund’s limited partners!). Again, it involves the preferred stock being paid on more favorable terms than common stockholders receive. Here the participating preferred gets to first receive a liquidation preference, and then receive a share of the sale proceeds as if its preferred shares had been converted to common stock. Even an investor would admit this is a “double dip”, and companies are wise to push investors to choose the liquidation preference over participating preferred rights (but not both), or at the very least introduce a “cap” whereby an investor can either use their participation rights to receive a set multiple of their original investment (say, 3x). Or, if it’s a better outcome, they can choose to convert to common and share in the proceeds of the sale. If it’s a home run they’ll choose the latter, but even a home run gets you one trip around the bases, not two.
4 – Anti-Dilution Protections
There are a number of types of anti-dilution protections, which fall broadly into categories of structural anti-dilution protection, right of first refusal or preemptive rights, price-based protection, and full ratchet anti-dilution protection. They all boil down to protecting investors in the event later financings result in the sale of cheaper equity, a.k.a. a “downround.” Luckily term sheets usually deal with anti-dilution protections summarily, and at the term sheet level the big takeaway would be that “Customary NVCA broad-based weighted average anti-dilution protection” is generally considered fair (whereas “full-ratchet anti-dilution protection” is not). In theory, full ratchet would seem fair to the investors who invested in a higher-priced earlier round, giving them the equivalent deal as later investors. In practice, however, the presence of full ratchet is likely to scare away subsequent investors, or force a workaround, meaning hybrid equity and debt financing to prevent triggering full-ratchet.
5 – Voting Rights (and Board Seats!)
That a Series A lead investor will receive a board seat is a given, but custom voting rights giving the Series A Board Member the right to veto day-to-day transactions, employee hires, etc., shows mistrust in the company’s leadership and existing board. I always push back on voting rights that misalign interests or shift power dynamics between the company and investor, or on the Board.
Also to look out for: Protective Provisions and “Matters Requiring Preferred Shareholder Approval.” I’m increasingly seeing investors–in cannabis businesses and elsewhere–seek the right to veto any transaction of total value exceeding X dollars, which I’m seeing as low as $50,000. This threshold for investor involvement is low enough to capture employee hires, purchase of equipment, and standard business partnerships. Wrangling shareholder signatures is not how company leadership should be spending their time, or holding up deals. At most, companies should agree to a higher dollar threshold or types of transactions, and board approval.
Why the First Terms Matter the Most
If you’re raising your first round (likely a Series A) it’s important to note that the rights you grant to investors now will form the basis for all subsequent rounds. This means that the Series B investors will seek equivalent rights as the Series A investors, and so on. If offered only inferior rights, they may seek a discount on valuation to compensate for this imbalance. All in all, if you’re considering equity financing to fuel the growth of your business, then the time to learn the terms is now–before you meet with investors and before you put together your first Series A term sheet. You certainly should not be “learning on the fly” over the course of your Series A round. Your investors will know the terms they want, and you should understand how the terms work and what will work for you.
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Author: Carlton Willey