Term Sheets for Startup Founders in Nigeria and It's Impact

For startup founders, navigating the complexities of term sheets can be daunting. These documents outline the key terms of an investment and hold significant implications for your company’s future, ownership structure, and financial standing. Understanding the potential impact of certain clauses is crucial to protecting your interests and making informed decisions during fundraising. This article titled “Term Sheets for Startup Founders in Nigeria” is about understanding Key Clauses in term sheets that Impact Startup Founders in Nigeria.

This article will break down key clauses commonly found in term sheets and explain how they may affect share ownership and dilution. It is a valuable resource for founders and Startup Attorneys

Introduction

Are you a startup founder in Nigeria facing the confusing world of term sheets? Imagine these documents as the blueprint to your company’s future, heavily influencing your ownership, finances, and overall success. Sounds important, right? Don’t go in unprepared! Understanding the fine print can be the difference between a brilliant deal and giving away too much, too soon.

This article is your insider’s guide on Term Sheets for Startup Founders in Nigeria. It breaks down the key clauses in term sheets that directly impact your share ownership and potential dilution. We’ll translate the jargon and reveal the strategies to protect your interests during fundraising.

Here’s what you’ll discover:

Decoding Share Preferences: Ever wondered what “preferred shares” really mean? We’ll explain how they affect who gets paid first if things go south (or when you hit that sweet exit!).
The Option Pool Puzzle: Investors asking for a bigger option pool? Learn why this seemingly small request can significantly dilute your ownership and how to negotiate.
Valuation Secrets: Pre-money vs. post-money valuation – it’s not just semantics! Uncover how these calculations can drastically change the equity you walk away with.
SAFE Agreement Traps: Using a SAFE? We’ll show you how valuation caps can either reward early investors or seriously dilute founders if you’re not careful.

Ready to take control of your startup’s destiny? Let’s dive in and equip you with the knowledge to negotiate like a pro and safeguard your equity!

1. Share Preferences

One of the most critical aspects of a term sheet is the share preference structure, which dictates how investors get paid in the event of a sale, merger, or liquidation.

Preferred Shares vs. Common Shares: Investors typically receive preferred shares, which grant them priority over common shareholders when it comes to distributions. This means that in case of a company exit or liquidation, preferred shareholders are first in line to be paid before any common shareholders receive their portion.
Participating vs. Non-Participating Preferred Shares: If an investor has participating preferred shares, they not only get their preferred share payout but also participate in the distribution alongside common shareholders. This can significantly reduce the payout available for founders and early employees.
Liquidation Preference: This clause specifies how much investors will be paid before common shareholders receive anything. A 1x liquidation preference means the investor gets at least their initial investment back before the remaining funds are distributed. If it’s 2x or higher, they receive double their investment before others get paid.

Class of Shares & Restrictions Under CAMA

Under CAMA 2020, the specific terms “common shares” or “participatory shares” are mentioned. However, the Companies and Allied Matters Act (CAMA) 2020 does discuss classes of shares and their associated rights.

The Act under Section 143 allows a company, if authorized by its articles, to issue any classes of shares. This share may be issued with preferred, deferred, or other special rights or restrictions regarding dividends, return of capital, or otherwise, as determined by ordinary resolution. See Section 144. The Act Further provides that the rights and liabilities attached to the shares of a company or any class thereof shall be dependent on the terms of issue or the company’s articles. See Section 138 of the Act.

An investor might request a specific class of shares that comes with certain privileges. While CAMA 2020 allows for different classes of shares with varying rights and privileges, it restricts the issuance of shares with disproportionate voting rights (i.e., weighted shares).

CAMA 2020 states that each share issued by a company should carry one vote per share in a poll at a general meeting, unless otherwise provided by another law (Section 140). This means that:

A company cannot authorize shares that carry more than one vote per share or that carry no voting rights at all through its articles or otherwise.
There are limited exceptions, such as preference shares under specific circumstances.

This restriction ensures fair voting power distribution among shareholders and prevents any party from having undue control through weighted voting shares.

2. Option Pool Increase

Investors often require a company to increase the size of the employee option pool as a condition for investment. While this might seem like a minor adjustment, it has significant dilution implications for founders. The option pool consists of shares set aside for future employees, advisors, and consultants.

Why Investors Want an Increase in Option Pool Size

There are several reasons an investor might request for increase in option pool size.

A major reason might be that the Investors have analysed the company and, based on the growth they’re expecting, determined that the existing option pool is too small to attract and retain the talent needed to achieve that growth. Then they recommend that the option pool needs to be large enough to cover all the employees the company needs to hire.

This is also a way to provide security for their investment. If the option pool is not enough to attract great talents to move the company forward, their investment may be affected.

Why Investors Prefer the Increase Before They Invest

Here is the Catch. An investor also prefers the option pool to be increased before they put their money. You might be wondering why.

The reason is that increasing the option pool dilutes all current shareholders, including the founders. Investors often push for this dilution to happen before they invest, ensuring their ownership percentage remains high while founders and existing shareholders bear the dilution.

Example: If an investor asks for a 20% option pool increase, it means founders must allocate 20% more shares from their existing ownership before the new investment is made, thereby reducing their percentage of the company.

Implications of Option Pool Increase:

There are some implications of option pool increase and they are below discussed:

For the Startup Founder:

The founder experiences dilution of their shares when the option pool is increased.
This means their ownership percentage decreases.
Founders may not realize they’re being exposed to this term in term sheets.

For the Investor:

By having the option pool increased before they invest, the investor avoids dilution of their shares.
This ensures they receive a larger ownership percentage for their investment.

This SMART move by an investor is not necessarily bad. You just need to be aware of it. This will help you negotiate better. Well, your Lawyers are there to help you. But make sure to get a VERY SMART Lawyer.

3. Valuation: Pre-Money vs. Post-Money

As I would always say, the dilution of shares is one of the founders’ nightmares in their Startup Journey. Well, if you get it wrong here, you might as well be making a bed with the founders nightmare – Dilution.

Valuation is one of the most crucial aspects of a funding round. A misunderstanding of valuation terminology can result in unexpected dilution for founders.

What is Valuation? In its simplest form, a valuation is the value of a company, essentially indicating how much money the company is worth. There are two key types of valuations to understand.

Pre-money valuation: The value of a company before it receives an investment.
Post-money valuation: The value of a company after it receives an investment

How Pre-Money and Post-Money Valuations Work:

Pre-Money Valuation Example: If an investor offers $3 million at a $10 million pre-money valuation, it means the company is valued at $10 million before the $3 million investment is added. After the investment, the company’s post-money valuation would be $13 million. The investor’s ownership stake is calculated based on the $10 million valuation before their investment. In this example, the investor is buying 23% of your company. $3 million / ($10 million + $3 million) = 23%

Post-Money Valuation Example: If an investor offers $3 million at a $10 million post-money valuation, it means the company is valued at $10 million after the $3 million investment is factored in. With a post-money valuation, the founder’s ownership is calculated after the new investment. If the investor offers $3 million at a $10 million post-money valuation, the company was worth $7 million before the investment. The investor is buying 30% of your company. $3 million / $10 million = 30%

Implication of Pre-Money and Post-Money Valuations For Founders and Investors.

The choice of pre- or post-money valuation is usually debated at a point of negotiation during fundraising. The investor often takes the lead in setting these terms. The investor may want the option pool to dilute existing shareholders before they invest in the company. That is, they may want the valuation to be Post-Money Valuation.

Just bear in mind that misinterpreting which valuation is being discussed can lead to unexpected dilution and a smaller ownership stake than anticipated.

Implications for the Investor:
With a pre-money valuation, the investor’s ownership is calculated based on the company’s value before their investment, potentially giving them a smaller percentage of the company than they might want.

But this changes with a Post-Money Valuation. Under a post-money valuation scheme, the investor’s ownership is calculated after their investment is factored in, which may ensure they receive the ownership percentage they are targeting.

Implications for the Startup Founder:

In both pre-money and post-money valuation scenarios, the founder’s share always experiences dilution when new investors are brought in. The difference lies in how the valuation is presented and how the investor’s ownership stake is calculated, which can influence the perceived impact on the founder’s ownership percentage.

4. Valuation Cap in SAFE Agreements

For early-stage startups that are not yet ready for traditional equity financing, Simple Agreements for Future Equity (SAFE) notes are a common funding mechanism. A SAFE is an agreement where an investor provides funding today in exchange for the right to receive equity at a later date—typically during a future-priced investment round.

Since SAFE investors are taking an early risk, they often negotiate a valuation cap, which determines the maximum valuation at which their investment will convert into equity when the next round of funding occurs.

What is a Valuation Cap?: A valuation cap is the maximum valuation at which a SAFE note will convert into equity during a future financing round. It protects early investors by ensuring they receive a better price per share than later investors.

Why It Matters: If a SAFE note has a valuation cap of $10 million, but the next funding round happens at a $20 million valuation, the SAFE investor’s shares will be issued as if the company were still valued at $10 million. This means:

The SAFE investor receives more shares for their investment than a new investor coming in at the $20 million valuation.
Founders and existing shareholders experience greater dilution because more shares are allocated to early SAFE investors at a discounted rate.

Example of How a Valuation Cap Works

A startup raises $500,000 through a SAFE with a $10 million valuation cap.
Later, the company raises a Series A round at a $20 million valuation.
The SAFE investor’s $500,000 converts as if the valuation were still $10 million, meaning they effectively get twice as many shares as a new investor paying the full Series A price.

While valuation caps are designed to reward early investors for their risk, they can significantly dilute founders if not managed carefully. It is crucial for founders to fully understand SAFE terms and negotiate fair valuation caps to balance investor incentives with long-term equity retention.

Founders Worry About Dilusion of Shares and My Advice

Founders often worry about dilution, which is the reduction in their ownership percentage as more investors take shares in the company. However, dilution shouldn’t necessarily be viewed negatively. Think of it like this, while the founder’s ownership percentage decreases, the overall value of their stake increases. Remember that in the early days, a founder might own a large percentage of a company that is worth very little. After raising funds and bringing in investors, the founder owns a smaller percentage of a company with a significantly higher valuation.

Although a founder’s ownership percentage may decline, the corresponding increase in the company’s value can lead to greater financial benefits. A founder may go from owning 55% of basically nothing to owning more than a quarter of a company that is valued at 37.3 million dollars. Although ownership percentage may also matter for other reasons like voting power and so on that’s a discussion for another day. At the moment focus on the influx of investment and strategic guidance typically leads to a substantial increase in the company’s valuation.

I remember what my mentor normally would say to me. It is better to own 1 per cent of the shares in JP Morgan Chase than to own 99 per cent of the shares of your community microfinance bank. Lolz. I hope you get the picture now.

Conclusion on Term Sheets for Startup Founders in Nigeria

Understanding the details of term sheets is crucial for founders to protect their ownership and make informed decisions. Some key takeaways include:

Negotiate Share Preferences: Be cautious about participating preferred shares and high liquidation preferences, as they can drastically impact your payout in an exit scenario.
Monitor Option Pool Expansion: Ensure that any increase in the option pool does not overly dilute the founders before investment.
Clarify Pre-Money vs. Post-Money Valuation: Make sure the valuation discussion is transparent to avoid unexpected dilution.
Be Strategic with SAFE Agreements: Understand how valuation caps affect future equity conversion and ensure they align with your long-term goals.

By carefully analyzing these clauses and negotiating when necessary, startup founders can safeguard their equity, optimize their company’s financial structure, and build a solid foundation for future success.

To learn more about Term Sheets for Startup Founders in Nigeria, I will refer you to Carta Resource on Term Sheets.

Thank you for reading this article on Term Sheets for Startup Founders in Nigeria. Feel free to engage and ask questions.