Term Sheets: The Definitive Guide for Entrepreneurs

February 3, 2016 Shareworks Marketing

As a founder or entrepreneur, you’ll likely come in contact with a term sheet at some point. As something that you typically don’t learn about in school, some founders consider term sheets to be part of the “street smarts” of being an entrepreneur. But what are term sheets, why do they matter, and what should you know about them?

What is a term sheet?

A term sheet is a non-binding document and agreement that outlines the basic conditions of an investment. Most often associated with startups, equity term sheets can be a key part of attracting VC investors.

The “terms” in a term sheet outline the “conditions” for an investment and describe specific aspects, such as the agreed upon valuation of the company, the price per share for the investment, the economic rights of new shares, and so forth. Generally speaking, term sheets can be drafted to not be legally binding. In that case, their main purpose is to serve as a blueprint for the more formal, legally binding contract that will be drafted. In most cases, each party agrees to confidentiality and a promise not to enter into negotiations with other investors at the same time. When raising capital, you may encounter term sheets for both equity investments and convertible instruments (such as KISS docs, SAFE docs, convertible debt, etc). In this article, we’ll primarily focus on equity term sheets. However, if you’d like to learn more about convertible debt, we encourage you to read out post on the topic.

 

An Overview of Term Sheet Negotiations: How to Negotiate a Term Sheet

 

When you receive a term sheet from a VC, the variety and depth of terms can be confusing, complex, and potentially challenging to wrap your head around. Even if the agreement is non-binding, investors will most likely expect you to honor the details outlined. Because of this, it’s important to understand how to negotiate conditions of a term sheet before you actually sign it. By understanding how term sheets work and what to look for, you can better understand if it’s in your best interest to partner with certain investors, and whether or not their goals and priorities line up with your own.

 

A final term sheet commonly contains the several key components:

 

 

Valuation (and percentage ownership)

The company’s valuation, along with the amount of money invested, determines the percentage of the company the new investors will own. This can be one of the most crucial components of the term sheet, because it often has the most direct impact on who owns what and how much cash each shareholder receives when the company sells.

Valuation is expressed in terms of pre-money and post-money values. The pre-money valuation is the company’s valuation before the new investment. The post-money is simply equal to the pre-money valuation plus the amount of the new investment. The founder’s basic objective is usually to maximize the amount of capital investment while minimizing dilution. If you don’t have a clear understanding of the valuation, it may have a negative impact on the outcome of the deal. However, a favorable valuation doesn’t always outweigh unfavorable terms elsewhere on the term sheet, so it is encouraged that you look at the term sheet holistically.

Option Pool

Many term sheets will stipulate the creation of an option pool or the expansion of an existing one to set aside shares for future hires prior to closing of the deal. Notice the phrase, “prior to the closing.” What this means is that the investors want some percentage of the cap table to be set aside for future grants, but they want existing shareholders to absorb all the dilution. The most founder friendly approach would be to calculate the option pool post-money and force the new investors to share in the dilution. But in reality, the standard for most term sheets is to calculate it pre-money, as in the above example. The option pool is a common source of information asymmetry, because some founders may not understand how VCs think about valuation.

The treatment of the option pool can have a significant impact on the valuation of your company. It affects dilution in a big way and may potentially impact the economics.

Liquidation Preference

The “liquidation preference” refers to downside protection for preferred stock. Investors typically prefer to see the company succeed so their stake in the company is worth more than they invested initially. But if the company doesn’t succeed, a liquidation preference gives them some protection from potentially incurring losses.

The most common liquidation preference is 1x invested capital, which means when the company is sold, preferred stockholders will be entitled to receive an amount equal to what they invested before more junior classes of stockholders can receive anything. Or instead, preferred shareholders can convert their shares into common and receive cash according their percentage ownership in the company.

Dividends

Dividends, usually expressed as a percentage (e.g., 8%), provide an additional return that accrues to preferred stockholders over time. Any dividends that accrue to preferred stock may increase the liquidation preference. Dividends are used to specify which investors get paid first and how much (for example, 1x or 2x their initial investments). Dividends are one of the most common contingencies found within term sheets.

As you review the documents language, you may see the word “cumulative” or the acronym “PIK,” which stands for “paid in kind.” Cumulative dividends guarantee investors a specific level of return, which is not commonly a feature of early-stage deals. In a PIK dividend, the value of the dividend is paid to the investor in the form of additional preferred stock. This can increase the liquidation for the preferred stock, and may dilute founders ownership stake with the passage of time.

Anti-dilution

Anti-dilution is another common feature of preferred stock and term sheets. It protects investors from getting diluted in the event of a down round. Anti-dilution comes in several different forms, which we cover in detail in our Dilution 101 article series.

Board of Directors

The board is a crucial governing body in any company, and term sheets will often include provisions on how it will be structured and who will control critical board votes. In many ways, the board can be most important control mechanism of the typical VC-backed company. As with other terms, there are more founder-friendly options and less founder-friendly options.  The company’s stage can heavily influence how likely a founder is to maintain control her company or not. Founders often maintain complete control over the boards of early-stage companies. But if they continue to raise money, often the investors (as a group) will gain more control than the founders.

Some investors feel that the ideal structure, even for later-stage companies, contains an equal number of VC-friendly members and founder-friendly members, as well as an “independent” board member. The independent member is usually a respected businessperson who is trusted by all other board members.

The primary objective for founders is often to ensure that board representation between VCs and founders/common shareholders stays equal. Under these circumstances, both sides have equal voting power. In a situation where the two sides disagree, both would need to leverage the independent member to vote gain a deciding vote in their favor.

Ownership Percentage of Share Classes

Some company decisions depend on a shareholder vote rather than a board vote. For these decisions, voting power usually comes down to percentage ownership. Majority ownership of the company may be held by founder-friendly shareholders or VC-friendly shareholders.

When like stock splits or dilutive issuances take place, issuing additional shares to new investors or employees may even require the approval of a majority of each share class, including common and all preferred stock. In these cases, the more shares controlled by each class, the more influence they have in the vote.

Investor Rights

Investors typically require special rights called “protective provisions” before they agree to invest. These special provisions may give investors special authority over specific company actions. Special provisions may include things like limits on how much debt can be taken on without VC consent, restrictions on increasing authorized shares to take on new funding or give to employees, and changes to the certificate of incorporation. Some provisions may be more common, while others may be rarer and stricter. While we will not list out the full list of potential provisions in this article, we encourage you to do further research on the topic.

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