Monetary Dynamics refers to the economics of the deal between the startup and investors. Mostly, it covers how each party will be compensated based on the different scenarios that might occur in the future. You can refer to the first article of the series to know more about the basics of monetary dynamics involved in a term sheet. 

Many startup founders might have a unidirectional view of how the startup will progress in the future, and keep building their startup according to their goals and vision. To the startup, it might seem like there’s only one way to go. However, investors have invested in many startups, and have witnessed different scenarios where the startup might not be able to pace up with their expectations. Since investors need to safeguard their investments, they might impose different conditions based on their own understanding of the startup and industry in context. However, startups might not focus on these terms, and any kind of unforeseen changes in the startup’s growth can lead to a significant loss of equity to the founders. 

In this article, we’ll focus on different terms involved in handling the monetary dynamics of the term sheet. Understanding these terms will give the startup a significant advantage over others in negotiations and help in securing an optimal deal. 

‘Monetary’ Terms

There is less variation in the different kinds of monetary terms included in a term sheet. The terms listed below cover most of the monetary aspects that investors want to address in the initial stages.  

1. Price: This covers the valuation and the pricing details at which the funds are being raised. Though it refers to the price per share of the startup, this section covers many other aspects of the deal. Other important terms are listed below:
   
   Pre-money and post-money: A startup’s valuation before funds are transferred to the company is called pre-money valuation. Once the funds are secured by the startup, the pre-money + funding amount combined is called post-money valuation. It’s essential that the startup gets clarity on the valuation terms being used by the investor. A simple misunderstanding can create a lot of difference in equity secured by both parties involved.
   
   For example, let’s consider that an investor says that he/she will invest 1 million dollars at 5 million valuation. If we assume that the investor will invest 1 million at 5 million post money valuation, it means that the investor will get 20% of the equity, and the founding team will have 80% of the equity. However, if assume the investor will invest 1 million at 5 million pre money valuation, it means that the post money valuation will be 6 million, and the investor will get 16.7% of the equity. The founders will get 83.3 % of equity.
   
   Warrants: This clause provides an option to the investor to buy shares of the company at a specified price irrespective of the actual share price at that point of time. Such clauses provide more advantage and flexibility to the investor. However, it increases unnecessary complexity in the term sheet. 
   
   In general, it’s best to avoid warrants and suggest a lower pre-money valuation so that the investor can get the needed advantage. However, it will vary depending on the situation in context.
   
   
2. Liquidation Preference: This section covers how the startup’s assets will be distributed among different stakeholders in case of sale of the startup or majority of its assets. It comprises of two major aspects, i.e. actual preference and participation, both of which are explained below: 
   
   Actual Preference: It mentions about the specific multiple of invested amount at which the investor will receive the proceeds of the liquidation event. It could also include any form of dividends that needs to be paid to the investors.
   
   Participating Preference: It mentions about the amount that the investor will receive after the actual preference has been paid. This amount will be equal to the proportion of equity stake the investor had in the company. 
   
   There can be other conditions too, like capped participation, which limits the maximum amount an investor can take during liquidation. However, actual and participating preferences are usually included in most of the term sheets. To understand the dynamics of such a clause in detail, you can go through the example shared in the previous article.
   
   
3. Pay to Play: This term is useful in scenarios where the startup is struggling with funds and needs some financing to reach the next milestone. In such situations, it is also possible for the startup to have a down round of financing, i.e. financing at lower valuation than previous round. 
   
   The general idea communicated by this clause is that, in case the startup struggles with funds and needs some support, the previous investors need to invest on a pro-rata share of their investment to ensure their stake in the company isn’t diluted. The clause can be made more aggressive or friendly by fine-tuning the additional details of the clause. 
   
   This term is more beneficial for the startup, since such terms ensure that the startup survives even in bad situations. Moreover, it also shows the commitment the investors have on the startup.
   
   
4. Vesting: This term refers to the process in which the founders and other early stage employees will secure ownership of their equity. This term is included in the in sheet by investors to ensure that the early founding team don’t leave the company. And, even though any of them leaves the company, most of the equity will remain with the company, which will ensure that the team has enough stake to offer any other qualified personnel. 
   
   In general, the vesting of founders’ equity will be distributed in 4 years, where the ownership of first 25% of their equity will be secured after finishing the first year, after which the  founder will receive equity on a prorata basis, till the end of 4 years. The terms might vary depending on the discussions between the investors’ and founding team, but the general structure remains the same. 
   
   
5. Employee Pool: Employee pool is another very important term that is heavily focused by the investor. In general, as the team scales, the startup will have to scale the team and hire members who have the needed expertise. However, experts will also expect significant compensation, which would also include stock options. Issuing shares for new members would mean equity dilution to the existing investors, which isn’t preferable for them. 
   
   To avoid such situations, an investor would ask the founding team to separate a chunk of equity as Employee Pool at pre-funding stage. This pool will be used for hiring qualified professionals during startups’ growth. 
   
   Doing this will reduce the founder’s equity, since some of their stake is being used to create the employee pool. To avoid such scenarios, the founding team can discuss with the investor and come to a common ground, i.e. increase pre-money valuation, limit the ESOP Pool to 15% if the investors’ ask is too much, etc. 
   
   
6. Anti-dilution: This term is included by investors to prevent the dilution of investors’ in case the startup goes to raise funds in the future at lower valuation. 
   
   This term is included by most of the investors, since they can’t risk their investment losing its value. However, startup founders can moderate the constraints imposed in the clause. 
   
   Broadly, there are two types of anti-dilution criteria, i.e. ratched-based and weighted average based. Ratchet based can be of multiple forms based on the amount of security the investor wants on the investment, or the leverage startup has on the investor. Weighted average is the more commonly used one, where the dilution numbers are established based on the mathematical relationship established between new conversion price, old conversion price, and other related parameters. A complete detail of anti-dilution criteria and how it works will be shared in the upcoming articles. 
   

In the Final Analysis

‘Monetary’ terms are important because it influences the distribution of equity or amount based on how the startup fares in the future. The founding team might believe that only the best case scenario will happen to them. The team might ignore the clauses unrelated to the best case scenario. However, not everything might happen as expected. It’s best if the founding team also keeps other possibilities in mind.

This list covers most of the monetary terms involved in a term sheet. You might encounter many other new terms based on the situation in context, but this is a good starting point. Understanding these will help founders ensure they negotiate well and don’t lose significant equity in the future.