Entrepreneurs looking to rapidly grow their startups, oftentimes turn to external financing. From the very first pitch deck, through negotiations, and until receiving the investment, there is a document known as a term sheet. This document reflects the fundamental terms and conditions under which an investor can fund a startup and will apply for the duration of the relationship with the founders.
Term sheets are important and can be quite complex, but they don’t necessarily have to be. The key is to know what to expect, what should be included, and, of course, what should be negotiated.
What is a Term Sheet?
A term sheet is the first formal document –however, non-binding– between the founder and investor. It’s a document similar to a letter of intent, that establishes the terms and conditions of the investment, but is not a required document for both parties. It’s essential to know what this document contains, since once the negotiations are made, the rights and obligations that have been agreed on will have to be written in the investment contract. In a few words: It’s the roadmap that leads to an investment.
The objective of the term sheet is to describe what the startup is offering, and what it is receiving in return. It establishes the guidelines for how each party should act to protect the investment. This document is generally written by the investor, who proposes the investment according to the terms reflected in the term sheet. Yet, while there isn’t a universal format to unravel what is to be expected in each term sheet, they tend to follow similar schemes. There are many templates available online that can help understand what they are and what they contain.
In his book The Art of Startup Fundraising, Alejandro Cremades gives some examples of how term sheets can be really scary for start-up founders, as it can be a very lengthy document loaded with technical terms. This panic contrasts with the excitement of finally closing an investment, which results in entrepreneurs usually giving in to terms without truly knowing what they are getting. A company might regret making this decision when it grows or in its next investment rounds.
Term sheets are not something that entrepreneurs should overlook. However, keeping in mind that not all of us are financial analysts, lawyers, or experts on the matter, here are some key concepts so that any entrepreneur can understand the basics of a term sheet.
What’s in a Term Sheet?
Every term sheet is different, which is why there are several variables that should be taken into account when creating one, such as the type of funding round, how much is at stake, and who is involved.
In general, term sheets for seed-stage rounds tend to follow a certain structure and are much simpler. The reason behind this is that it saves money! At those stages, nobody wants to waste money unnecessarily on additional legal fees. Therefore, these investments have friendlier term sheets with significantly simplified processes. In more advanced stages, this would not be logical, nor wise, since larger investments without legal advice could have serious consequences.
Term Sheet Sections
Although term sheets will differ depending on the startup’s specific characteristics and needs (as well as the investor’s), term sheets usually follow a general structure that can be divided into three basic sections:
- Investment-related aspects (funding)
- Management of the startup
- Future share settlement events
These sections generally contain the following terms:
- Parties to purchase of interest: Purchaser (Investor) and Company
- Proposed purchase price
- The valuation
- Shares and price
- Conversion options
- Statements and Assurances
- Non- Disclosure
- Non- Compete
- The Assigned interests are free and clear from obligations
- Terms and Conditions of the Series stock
- Liquidation Preference
- Conversion Rights
- Anti-dilution Rights
- Drag Along Rights
- Governing law
- Voting rights*
- Board seats*
- Anti-dilution provisions
- Deliverable at closing and Date of closing
- Signatures
*Depends on the investment amount
Negotiating a Term Sheet
The most important aspect of a term sheet, after determining its components, is learning how to negotiate the terms that interest us the most. The following is a summary of the terms that require extra attention in this process, along with some advice on how to approach the negotiations.
SHARE PRICE AND VALUATION
Even though valuation can be the most important part of a negotiation, it shouldn’t become an obsession. Sometimes, we can give in to it and negotiate other aspects that in the future can be just as important, such as the control of the company. Most entrepreneurs dedicate so much time to valuation that they neglect other aspects, such as investors’ rights, anti-dilution, or seats on the board.
The valuation of non-listed companies can be a complex issue. This process is usually associated with complex calculations and therefore thought of as an exact science. This can be useful for mature companies but for early-stage companies, you need to consider some subjective variables like the management team, the size, the uniqueness of the technology, the stage, etc.
- Pre-money and Post-money valuation: the value of the company, immediately prior to the investment. The pre-money valuation needs to be determined in order to set the shares price for a proposed investment. And as the name implies, post-money valuation is the mathematical value of the company after the investment has been made.
- Formulas:
- Pre-money valuation = Number of shares of a company * Price per share at which the investment was made.
- Post-money valuation = Pre-money valuation + New investment
PRIORITIES POST-VALUATION
After the valuation, these are the points that should be prioritized since they will determine the control that founders will have of the company after the investment is made:
OPTION POOL
- The option pool is the term used to refer to an amount of equity reserved for future hires and is a common tactic for attracting talent to a startup. This is entirely for the benefit of the company and not specifically for the entrepreneur or the investor. However, it is necessary to be cautious since a very high number of these option pools dilute the founders. You can use an Equity Simulator tool to help model varying option pool sizes, and assess their impact on pre-money/ post-money valuations and dilution.
- The shares reserved for the purpose of issuance upon the exercise of outstanding options are collected in an employee pool or option pool.
- The terms and conditions under which the employee options can be granted, exercised, and transferred are usually set out in an arrangement called employee stock options plan or ESOP.
- The standard is 10-15%, this provides sufficient room to incentivize and attract key employees.
LIQUIDATION PREFERENCES
- This clause specifies how much of the proceeds of a liquidation event the preferred shareholders can collect before any of these proceeds are distributed to the holders of common shares. To understand this clause you should understand:
- Common or Preferred stock: Common stock is the most common type of stock companies issue. Preferred stock offers additional benefits to the investors including rights over common shareholders, and in these rights, the liquidation preference is included.
- Liquidations events: means any liquidation, dissolution, or winding up of the Corporation, either voluntary or involuntary.
SEATS ON THE BOARD
- This term can almost appear ridiculous for an early-stage startup, but it is important nonetheless, considering that it is expected that the company will undergo rapid growth in the years that follow. As a result, most term sheets include a section about the Board of Directors. According to Brad Feld and Jason Mendelson in Venture Deals,
“Your board is your inner sanctum, your strategic planning department, and your judge, jury, and executioner all at once. Some VCs are terrible board members…”
- For that reason, you must be careful when you assign chairs on the council. You must be sure that it is a fund that you would like to have. Having a member of the fund as a member of the board is generally helpful for the company as it may provide a different perspective on their experience. Make sure that the fund has the elements that help you in this regard.
- A typical board for early-stage startups looks like this:
- Founder
- CEO
- VC
- A second VC
- An outside board member.
Last Piece of Advice
- Valuation is only a part of the negotiation.
- The person (or the fund) that you will partner with is extremely important.
- “The more rights that your investor requests, the more rights will accumulate in future agreements since the future investors will expect the same terms as the previous round of capital,” said Shanna Tellerman, CEO of Modsy.
- If you have doubts about what anything means, ask.
This article is not meant to provide legal advice. It should be understood as a simplified overview for readers to consult with their legal advisors as every situation is unique.