As an entrepreneur and founder, you will come across a lot of important documents on your journey. One of the most important ones that you will most likely encounter is term sheets.
Since things like terms sheets rarely appear in a school curriculum, you, as an entrepreneur, will need to make an effort to learn all about them on your own. You can find examples and templates of term sheets online. However, you may still have a hard term figuring out some of the technical terms that the document might contain.
This article will break down all of these terms so that you not only know what a term sheet is but also get a good idea of preparing one. We’ll cover some of the commonly used jargon, why it is so important, and how it affects your negotiations.
All of these will prove useful going further in your interactions and business decisions that may involve a term sheet.
Let’s start by defining what term sheets are.
What is the term sheet?
In a nutshell, a term sheet is like a marriage contract between your company and investors, although there is a lot less romance involved.
As a startup looking for investors, you will probably have to approach several investors until one of them eventually agrees to fund your company. Typically the first sign of your success with a prospective investor is the term sheet.
It is a non-binding document that lays out all the proposed terms under which an angel investor or venture capitalist will invest in your company. Generally, a term sheet is usually between 1 and 5 pages in length.
This crucial piece of document will be the framework for further negotiations. Also, the eventual contract with the investor will be mainly based on the terms of the term sheet, even though the sheet in itself is not binding on any party.
A term sheet can be prepared by either of the parties involved in the agreement. Although a crucial piece of documentation, many startup founders either don’t know enough about term sheets or are happy that they take whatever investors offer.
If a deal closes based on the terms of the term sheet, it can have serious long term implications on your startup if such terms are unfavorable. Not only do you have to be familiar with the terms to look out for, but you also have to be a good negotiator.
A term sheet can be prepared to cover for both convertible instruments and equity investment. This article will be focusing mainly on term sheets for equity investment since it is the most common documentation of the two.
What does a term sheet contain?
A Term Sheet is essentially about two things; control of your company and the economics of the business (cash to be received in case of an exit event ).
Since these two elements will play a vital role in determining the future of your business, you will need to understand how every detail in the term sheet affects you. It is a make or break moment and will determine whether you want to go ahead with the deal on those terms, open to negotiations, or simply calling it all off.
The term sheet also analyzes the upsides and the risks of the business. Knowing the things to negotiate and what to push for is essential to reach a mutually beneficial agreement.
Hence, you need to take note of some of the standard clauses included in the sheet and what they mean. While the overall situation of an agreement may differ, these standard clauses remain largely the same for all term sheets.
A term sheet is also a crucial key to knowing who your prospective investor is. By taking note of the things they are pushing for, you will get a good idea of what to expect in your future dealings.
Needless to say, understanding the content of a term sheet before proceeding with any deal is crucial and must not be taken for granted.
Why is this important?
Again, there is a need to emphasize why understanding term sheets is important. A lack of sufficient knowledge and clarity in regard to this document will put you at a serious disadvantage.
But don’t get paranoid yet. This isn’t to say that VCs are out to dupe you or buy you out of your business. Understand that every investor is in the deal-making business. This doesn’t only mean they know more about how things work, but they also know how to negotiate to get the most out of every deal.
They will do their best to get the best deal for their company. It is in your best interest that you educate yourself enough so that you don’t end up on the wrong side of the negotiation table as well.
Now that you understand what a term sheet is let’s get down to the technical details beginning with some key terms.
Shares are the reason why we are talking about term sheets in the first place. Therefore, you need to understand how they work, and the different types of shares there are.
To begin with, if you already have a company set up by the time investors are coming in, then you are likely to have created common shares already. However, when an investor comes in with more funds for your company, a new class of shares will have to be created. Some specific clauses and terms will also have to be determined to clarify the impact of this new share class on your business.
Those who hold the common shares in your company will typically have fewer voting rights and less claim to the company assets. For the preferred shares (which are by definition higher than those with regular equity or common shares), a new set of rules will have to be in place.
This will be of optimum importance in decision making as well as liquidation issues. Venture capitalists and angel investors are typically issued preferred shares. Hence, this article is about term sheets as it’s related to equity for preferred shareholders.
Deal economics- important terms
This part of the deal is basically about who gets what under your new agreement. This is important because the logic of opening your doors to investors in the first place is to help you get a smaller part of a bigger pie instead of a big part of a small pie. At the same time, you want to keep your share of the pie protected, or you might lose it entirely. This is why you must understand the deal economics and all the terms associated with it.
1. Valuation and percentage ownership
The valuation of your company and investor’s involvement will determine the percentage of the company that you and the investor will eventually own. Hence, understanding how the assessment works is one of the most crucial parts of a term sheet.
This determines the percentage of each party and also determines how much each party gets in case of liquidation.
The valuation of a company as far as a term sheet is concerned is in terms of pre-investment and post-investment values. This is the pre-money and post-money value of the company being valued.
The pre-money value is how much the business was worth before a new investment. On the other hand, post-money value is how much it will be worth after the new investment is received. This is the sum of the new investment and the pre-money valuation of the company. Your goal when negotiating is to maximize capital investment while minimizing the dilution.
As mentioned, the valuation also determines the percentage ownership of the business. So let’s say your company was worth $4 million after the pre-money valuation, and the VC will be investing 1 million raising the post-money value of your startup to $5 million. The implication is that the new investor will now own 20% of your company if the deal pulls through based on these terms.
The impact of the valuation on the other components of your term sheet is quite interesting. A poor valuation can ruin your deal even if all the other terms are in your favor. However, a great valuation doesn’t automatically guarantee a great deal if you don’t get all the other terms right. This is because investors can still extract more value than a valuation grants them using the other terms of the contract.
Another reason why understanding valuation and its impact is important is that it sets crucial precedence for subsequent rounds of investments. Hence, it’s better to approach the subject of valuation with a level head and be a smart negotiator.
2. Option Pool
This is another term you will most likely encounter in a term sheet.
An option pool is a share of a company’s equity reserved for employees, consultants, or directors of the company in the future. This is a crucial tool a lot of startups use to attract top talents to their company.
Investors know how important setting aside an option pool is and also know that doing so pre-investment will have a less dilutive effect on their share as investors. In fact, allowing an option pool to be created “prior to the closing” will dilute your equity as a founder and put you at a disadvantage.
The recommended move when negotiating an option pool is to calculate it on a post-investment basis. This way, the investor also shares in the dilution as well. However, in most cases, the option pool is eventually calculated pre-money.
This may work to your advantage during negotiations.
One of the rights-holding a preferred stock grants an investor is the Conversion right. This refers to the right of an investor to convert preferred shares into common shares at the conversion rate stipulated in the agreement. Conversion rights can be optional or mandatory.
- Optional conversion: it gives the holder of preferred shares the right to convert their shares into shares of the common stock if they want. For example, in case of a $1 million non-participating investment with a liquidation preference of 2x, it represents 25% of the company. One the sale of the company for $50 million, the investor will get only $2 million based on the liquidation preference (2x). However, if an optional conversion clause is in place and the investor makes the decision to convert share to common stock, the VC gets $ 12.5 million (based on the 25% stock ownership of the company).
- Mandatory Conversion: also known as an automatic conversion, this conversion right mandates the holder to convert the shares into a common stock share in case of a predefined event like an IPO. The major difference between both conversion rights is that while the optional conversion can be negotiated, the mandatory conversion isn’t negotiable.
Remember what we said about the conditions in your term sheet affecting future deals? This is one major area this comes to play.
The anti-dilution clause is simply a way for the investors to protect themselves against dilution when you receive subsequent rounds of investment. This is particularly important in case of a down round ( I.e., if the price per share for the second round of investment is less than the price per share for the first investment round). The effect of anti-dilution depends on how it is described in your term sheet documentation.
Full ratchet: In case of a full ratchet anti-dilution, when a down round occurs, the price per share for the first round of investment will be reduced to the current value the share is being sold for the second round. This means Series A (the first investment round to which the current term sheet applies) will get repriced if Series B (a future investment round) is selling at a lower price per share.
For example, if your company with 100,000 shares sells at $10 per share for Series A investment round, an investor that invests $1 million now holds 100,000 shares. At the same time, you hold the remaining 100,000, which is half of the company.
But if the next round of investment is a down round and due to a full ratchet anti-dilution clause, the Series A stocks get repriced to $9 per share. Since the original investment amount remains $1 million, the preferred investor in Series A now holds 111,111 shares against your 100,000, which leaves you with only 47% instead of your original 50.
The preferred investor from Series A becomes the majority shareholder due to full ratchet anti-dilution. It’s a lot of complicated maths, but you should be able to wrap your heads around it if you take your time.
Weighted average: this is a more commonly used anti-dilution clause. It is more friendly to the founder than full-ratchet because it considers the number of shares issued in Series B investment round in calculating the anti-dilution effect.
Generally, the formula for the weighted average system is NCP = OCP * ( (CSO + CSP) / (CSO + CSAP))
- NCP is the new conversion price
- OCP is the old conversion price
- CSO is the common shares outstanding immediately prior to the new issue
- CSP is the common share purchased if the round was not a down round (at Series A pricing)
- CSAP is the common shares purchased because the round is down
There are two versions under this system. This includes the broad base anti-dilution system, which takes into the amount of share-based on the fully diluted capitalization for the business.
The narrowly based system only takes into account the common stock. Both options can be negotiated, and your target as a founder should be getting a broader base. Also, during negotiations, you can push for the investor in a down round to put in more capital to get anti-dilution rights.
Important terms relating to control
On the most basic level, the issue of control on a term sheet is pretty much straightforward. Either you have it, or you don’t. However, there are still various elements of control to put into consideration during your negotiating.
- Voting rights
This refers to the rights of shareholders to vote on issues relating to corporate policy. Not only does a term sheet state how voting rights will be divided between shareholders, but it also clearly states matters where voting will be required.
This includes issues such as:
- Issuance of securities
- Changes in the shared instrument
- Share repurchase or redemption
- Dividends payouts or declaration
- Changes in board directors
- Sale or liquidation
- Annual spending
- Bylaw or charter changes
The implication of your term sheet on voting power depends on how the voting majority is defined in the document.
For example, if the term sheet states that a preferred majority approval is needed for any of the actions stated above, it means the preferred shareholder holds the veto power over these decisions.
Similarly, the term sheet may also state that a common majority is required. This means the consent of the common shareholders is required for a decision to hold. However, bear in mind that preferred shares may also have common voting rights in some cases too.
2. Board of Directors
This is the most crucial control mechanism in any company backed by venture capitalists. A term sheet is expected to include how this important governing body will be structured as well as provisions for its composition.
A company’s board of directors is usually composed of VC friendly members, founder-friendly members, and independent parties (usually a respected third party trusted by all members of the board).
Just like the other conditions in your term sheet, the composition and power of the board of directors can either be for or against you. Typically, for early-stage companies, the founder can easily maintain complete control over the board. However, as you continue to raise more money, and the number of investors increases, the founder will lose more power, and the investors as a group will have greater control.
As a founder, you should try as much as possible to keep the number of investor and founder-friendly board members equal. This gives either party equal voting power. Not only is this good for you as a founder, but it is also healthy for the business. Both sides will have to convince the independent board member on the benefits to earn a vote in their favor.
3. Investor Rights
Investor rights refer to clauses in a term sheet that should help investors in protecting their investment. These provisions are trump cards that give the investors certain rights to make or alter some specific decisions.
Considering their importance, you must pay attention to this section of the term sheet so that you do not agree to terms that will come back to bite you.
Some examples of investor rights include:
- No-shop clause: This is typically included in a term sheet to keep a company from shopping around for investment proposals from other parties after the term sheet has been signed. While the no-shop clause is included in most term sheets, you should consider the time frame stipulated for it. This way, you don’t end up getting tied to an investor for too long only for them to drop out at the last moment. A standard period of 45-60 days is used in most cases.
- Pro-rata clause: This is another highly sensitive investor right clause. The pro-rata or pre-emptive right clause makes it possible for investors to maintain their equity by participating in subsequent investment rounds of the company if they want to. This helps investors to prevent dilution of their stocks. The pro-rata right give preferred investors the right to buy future issues of common stock (proportionally) before non-holders or common shareholders. Pro-rata rights may put you in an unwanted position when dealing with investors that want a sizeable portion of your equity before investing. If there are a lot of preferred investors with pre-emptive rights on your board already, you may not be able to meet the equity needs of the new investor. Because of that, you may lose such investments. Similarly, pre-emptive rights may also lead to a case where unwanted investors become shareholders in your company. This can occur when investors with pro-rata rights sell their rights. However, you can include limits on the term sheet that prevents this.
There are other clauses commonly used in term sheets that do not relate directly to control or economy but are also quite important.
- Drag-along tags: this tag makes it possible for a majority shareholder to force a minority shareholder to share their shares for the complete sale of a company.
- Redemption clause: this clause allows investors to demand redemption of the stocks they own in a company within a specified time frame.
- Founder-vesting: this clause makes it impossible for a founder to walk away from a company without losing their share of the equity.
Knowing all of these terms and details of what a term sheet contains will come in handy in your future term sheets negotiations.
Of course, you can also find a good lawyer or business to help you go through such negotiations. That way, you don’t have to agree to terms and conditions that will come back to bite you.