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deal terms

Evaluating Deal Terms in Crowdfunding Investments Part 1: Straight Equity

Angel investing, in this case through crowdfunding platforms, involves at least one step that you don’t normally undertake when investing in public securities: evaluating deal terms.

For most investors, crowdfunding is the only practical way to diversify into private securities. Regulation Crowdfunding (Reg CF) allows all Americans to invest small amounts – often as little as $100 – in shares of startups and growing small businesses regardless of their income or net worth.

When you find a Reg CF equity offering that seems attractive, and you like its industry, innovative product or service, executive team profiles, business plan, and financial projections, then your next step is to review the term sheet, which sets forth rights, obligations, and restrictions that apply to both parties in the deal.

Offering terms vary from one kind of deal to another. Deal terms for a preferred stock offering are different from the terms for a convertible debt offering, for example. Terms for a seed-stage, pre-revenue startup may differ from terms for a growing, established company. There is no single standardized set of terms for all kinds of equity offerings, just as there is no single standard lease for all kinds of commercial real estate.

Securities: Straight Equity, Convertible Debt, Future Equity

One of the first terms you see at the top of page one of a term sheet is the type of security being offered. The four most common securities offered in equity crowdfunding are

  1. Stock
  2. LLC membership units
  3. Convertible debt
  4. Future equity

Stock and LLC shares are straight equity, while convertible debt is a hybrid of equity and debt. Future equity is a new warrant-like security, formally known as a “simple agreement for future equity” (SAFE).

We will start by explaining the most important deal terms that you (or your adviser) should know about for straight equity offerings. These include economic terms, control terms, terms related to liquidity events, and other terms.

Deal Terms for Straight Equity

  1. Economic Terms

When you invest in straight equity (e.g., common stock, preferred stock, or LLC shares), the first terms that you will consider are

  • Price per share (either a fixed dollar amount or a formula)
  • Minimum investment amount (and additional increments permitted)
  • Valuation of the company
  • Percentage of total equity offered per incremental amount invested

Many offerings state a certain share price of stock or price per unit of LLC membership. The price alone is not meaningful unless you also know the percentage of ownership a share or unit represents. Extra-thoughtful issuers will give you both figures, but many do not. In any case, they must give you enough information — such as the company’s (proposed) valuation and the total number of existing shares or units — to calculate the percentage of ownership that you get when you buy a share, using one or more of these formulas:

100 ÷ Total shares issued = Percent ownership of each share

Investment amount ÷ Company valuation = Percent ownership for the investment amount

To make these formulas meaningful, we need two definitions:

Total shares issued means all shares held by the issuer, granted to employees and directors, sold to investors, and authorized for sale (and held in reserve as employee options) in the current round of financing.

Company valuation is the value on a specific date as proposed by the issuer or, in some cases, as estimated by a third-party valuation analyst hired by the issuer. For private companies, valuation is a highly subjective measure. In a private securities offering, valuation is usually stated in pre-money terms (that is, the value before the current round of financing), although it is sometimes stated in both pre- and post-money terms.

The issuer should reveal what approach, method, or multiple it used to estimate its valuation, and the date on which the valuation was effective—as it can change from month to month. Angel capital valuations typically fall into the $500,000 to $10 million range, although outliers certainly come along.

How do you know if the price is fair? Of course, investors (buyers) want the price to be low, while issuers (sellers) want the price to be high, as in any free-market transaction. Some inexperienced, starry-eyed entrepreneurs assign their startups exaggerated valuations. You should try to judge whether the valuation seems reasonable, as the price is derived from the valuation, but not try to narrow it down too precisely. The key to success in angel investing is not necessarily buying in at bargain prices but buying shares of potentially great companies at fair prices.

  1. Control Terms

As an equity crowdfunding investor, you will probably hold a hyper-minority share of the company in which you invest — that is, a tiny percent of the equity — among dozens or hundreds of other investors in your funding class. One disadvantage of hyper-minority ownership is that you, as an individual (as opposed to your investment class as a whole) will have very little control over, or participation in, the governance and day-to-day management of the company.

Gaining even a small amount of control should not be one of your goals when you invest in equity crowdfunding deals. A lack of control should not, however, discourage you from investing in equity crowdfunding deals that let you achieve your social and/or financial goals.

Protective provisions. The terms of the deal should afford your Series CF class, collectively, a measure of control over a narrow set of actions that relate to the long-term value of your equity shares. This narrow area of control will be in the form of protective provisions, also known as veto rights. A typical set of protective provisions in an angel investment states that a supermajority (such as two-thirds) of the Series CF shares can veto any action, whether directly or through a subsequent round of financing or a merger, that:

  • Adversely alters the rights or preferences of the Series CF Preferred.
  • Increases the authorized number of shares of common or preferred stock.
  • Creates any new class or series of shares having rights or preferences senior to Series CF Preferred.
  • Results in any merger, corporate reorganization, sale of control, or any transaction in which all of the assets of the company are sold.
  • Results in the redemption or repurchase of any shares (other than pursuant to the company’s right of repurchase at a specified cost, if so provided by the terms).
  • Changes the authorized number of directors on the board.
  • Liquidates or dissolves the company.

Those are some of the more common protective provisions in angel deals, and there are others. Any given angel or VC deal may have several protective provisions, but rarely all in the term sheet. In an equity crowdfunding deal, you might be satisfied with the first one, or maybe the first three, on that list.

  1. Terms Relating to Liquidity Events and Future Financing

The most important factor that drives ROI is consistent growth in profitability of the company in which you invest, or at least the potential for such growth. That in turn makes it a good acquisition target or IPO candidate. Along the way, however, several other factors can strangle your return on investment in large and small ways.

Those factors include

  • Dilution of share value caused by the issuance of new shares for future financing rounds
  • Distribution of whatever proceeds might be available in the event of the dissolution of the company
  • Sale of the company at a price lower than the Series CF valuation

Those are three examples of liquidity events that could result in a disappointing return, if not an actual loss, for investors.

Liquidation Preferences

The term sheet should include liquidation preferences to protect equity crowdfunding investors, who are in the first round of equity financing outside of friends and family. The preferences protect investors from potential constrictions of those adverse or “downside” liquidity events.

If you invest in 10 equity crowdfunding deals, chances are you will experience a few liquidations. When a company calls it quits, whether voluntarily or otherwise, it must liquidate its assets in order to pay salaries and wages owed to employees first, repay its creditors and noteholders second, and return money — if there is any left — to its investors third. Holders of preferred stock generally have priority over common stockholders.

Liquidation preferences spell out the amount of money, stated as a multiple of their original investment, that preferred shareholders receive in the event of a dissolution or sale. Only after preferred receives its full amount will common (including the founders) get any leftovers. To see a typical liquidation preference, see Chapter 11, “Deal Terms,” in Equity Crowdfunding for Investors, by Freedman and Nutting (Wiley & Sons, 2015).

Sometimes the company is sold at a much higher valuation than in the Series CF deal (we’ll call this an “upside” acquisition). Liquidation preferences may let preferred shareholders convert shares to common stock in order to benefit from the capital gain common shareholders enjoy. Common stock prices rise and fall freely with market valuations, whereas preferred stock prices are protected — and restrained — from market volatility.

So liquidation preferences can give early investors, as a reward for taking a big risk, the best of both worlds. They get the downside protection of preferred combined with the upside benefit of common.

Aside from liquidation preferences, other terms relating to liquidity events that might appear in your deal include

  • Full participation
  • Anti-dilution provision
  • The right to participate pro rata in future financing rounds
  • “Pay to play” and drag-along agreements

These are explained in Chapter 11 of Equity Crowdfunding for Investors (see reference above).

  1. Other Deal Terms

The two deal terms in this group are no less important than the preceding ones; they just don’t fit neatly into the aforementioned categories.

Conversion rights

In addition to conversion rights spelled out in the liquidation preferences preferred shareholders may be granted the right to convert their shares to common stock either

  1. At any time of the investor’s choosing
  2. After a specific date, such as one year after the closing of the Series CF round or
  3. Automatically upon the occurrence of a certain event such as an acquisition or IPO.

You might exercise this right if you want to vote actively with common shareholders, for example, or if you think it would be easier to sell common shares on secondary markets. Once you convert to common, you can’t revert to preferred.

Whether conversion is at the investor’s discretion or only upon liquidation, this provision sets the conversion ratio — that is, the number of common shares the investor receives for each preferred share on conversion. The typical ratio is 1:1 unless it is adjusted according to an anti-dilution provision or a stock split (which is rare for startups).

Information rights

A typical term sheet in a Regulation D offering states that the company shall provide, at the very least, annual financial statements (reviewed or audited, depending on the amount raised) to each investor within a reasonable time. This provision may be unnecessary in equity crowdfunding deals because Title III requires issuers to do so anyway. Aside from Title III issuers, private companies are not obligated to share financial records with anyone. However, they may be compelled to do so by the terms of a securities offering, institutional debt financing arrangement, credit application, or certain legal or forensic proceedings.

In Part 2, we will discuss deal terms for two other kinds of securities besides straight equity: convertible debt and future equity.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

  1. Raising Capital: Negotiating with Potential Investors
  2. Best Practices Regarding Technology
  3. Crowdfunding from an Investor’s Perspective

©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.]

About Matthew R. Nutting

Matthew R. Nutting is a lawyer with the firm Coleman & Horowitt in Fresno, CA. He is an authority on crowdfunding. Matthew R. Nutting co-authored Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, NY, 2015).  

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About David M. Freedman

Dave Freedman has worked as a journalist since 1978, primarily in the fields of law and finance. He is a co-author of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, 2015). He currently analyzes turnaround stocks for Dave has also written extensively…

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