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.
NEGOTIATING A TERM SHEET
Term sheets can have many important aspects, however, it is helpful to know which you should save your energies for, and above all, how to negotiate them.
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.
- 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
OPTION POOL, LIQUIDATION PREFERENCES, AND SEATS ON THE BOARD
After the valuation, these are the points that should be prioritized since they will determine the control that founders will maintain of the company after the investment is made:
- 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.
- 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:
- 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.