IndyBar: Term Sheets and Equity Compensation for Early-Stage Companies

By Alexander R. Swider, Barnes & Thornburg LLP; Clarissa L. Walstrom, Frost Brown Todd LLP

Two essential considerations for helping facilitate growth in early stage companies are securing capital and incentivizing current and future employees by offering competitive equity compensation plans.

With respect to securing capital, a key document in this process is the term sheet, a non-binding agreement that outlines the terms and conditions of an investment. For startups, understanding the nuances of term sheets is crucial for negotiating favorable terms and securing the necessary funding for growth.

A key component of the term sheet is the valuation of the startup, which represents the agreed market value between the founders and investors. This valuation, similar to market capitalization in public markets, can be derived using various methods such as potential value at exit, comparable financings, or the Berkus Method. Investors in early-stage companies typically look for substantial returns, often ranging from 10-20x within 5-8 years.

Dividends are another important economic aspect of the deal. These can be structured as cumulative or non-cumulative and may either participate with common shares or be fixed. The terms of the dividends can significantly impact the attractiveness of the investment for both the company and the investors.

Liquidation preferences dictate the order of payout in the event of a liquidation. These preferences can vary from a simple return of the invested capital plus accrued dividends to more complex structures like 2x returns with participating rights. Understanding these preferences is crucial as they will affect the distribution of proceeds during a sale or liquidation of the company.

Control provisions are equally important in term sheets. Investors often seek board representation or observation rights to safeguard their interests. Veto rights on significant business decisions, such as issuing new shares, incurring debt, or merging with another company, are commonly included to provide investors with a level of control over key corporate actions.

Preparation is key to navigating term sheets effectively. Startups should document all stock issuance agreements, ensure all intellectual property is owned by the company, and prepare comprehensive business plans with realistic projections. The terms of the initial Series A round can set precedents for future funding rounds, making it imperative to negotiate carefully and seek experienced legal counsel.

Emerging companies should also consider establishing a competitive equity incentive plan to keep employees invested in the growth of the company. There are several types of equity compensation that emerging companies often use to incentivize employees, including stock options, restricted stock, stock appreciation rights and phantom stock.

Stock options are the most common form of equity compensation. Stock options give the recipient the right to purchase stock in the future at a specified price (also referred to as a “strike price”), but do not actually convey any compensation at the time of grant so there are typically no tax consequences at the time of the grant. Incentive stock options (“ISOs”) may only be issued to employees under Internal Revenue Code Section 422 and are not taxed when granted, upon vesting or when exercised. Instead, taxes are deferred until the shares are ultimately sold by the employee and taxed at the capital gains rate (absent a disqualifying distribution). Additionally, companies can grant non-qualified stock options (or non-statutory stock options) (“NQSOs”) to employees and other service providers. Although not taxable to the recipient upon grant, holders of NQSOs will have to pay taxes at the ordinary income rate on the difference between the fair market value of the shares on the exercise date and the strike price of the options and again upon sale of the shares at the capital gains rate.

Restricted stock, a grant of actual stock in the company to the recipient, is another commonly used equity incentive tool. It is non-transferrable and generally subject to a vesting schedule, but there generally is not a built-in strike price, so there is not a risk that the restricted stock will be out-of-the-money (i.e., that the strike price will be greater than the value of the underlying shares).

Unlike stock options and restricted stock, stock appreciation rights (“SARs”) are a contractual right to receive cash or stock equal to the appreciation in the value of the company’s shares from the grant date until exercised upon payment of the strike price. Similarly, phantom stock does not convey equity in the company to the recipient but merely provides the recipient with hypothetical shares, and the recipient is entitled to receive the full value of the phantom stock upon payment of a built-in strike price.

When considering an equity incentive plan, companies should carefully evaluate their objectives with regard to the plan and ensure that the plan is adopted and administered, and all awards are issued, in compliance with applicable tax and securities laws.

If you’re interested in learning even more, IndyBar’s Business Law Section hosted a CLE program in June that provides more detail and insight. This seminar is available for purchase online through our store at www.indybar.org/earlystage and is approved for 1.0 hour of General CLE credit.•

Alexander R. Swider is an associate at Barnes & Thornburg LLP where he advises private equity funds, large public corporations, and privately held companies of all sizes and at every stage of development on a wide variety of corporate law matters. Swider gained legal experience as a summer associate in the firm’s Indianapolis office and as a judicial extern for the Honorable Robyn L. Moberly of the U.S. Bankruptcy Court for the Southern District of Indiana. Swider is an active member of IndyBar’s Business Law Section’s Executive Committee.

Clarissa L. Walstrom is a Managing Associate at Frost Brown Todd LLP in the firm’s Corporate Law practice group. She assists clients in structuring, negotiating, and documenting complex business transactions, including mergers, acquisitions, divestitures, reorganizations, and capital and finance transactions. She also regularly assists clients with forming new businesses and restructuring existing companies.