A Look at Term Sheets

Picture this: As a founder of company looking to raise capital, you decide to meet with a few seed investors. You present your pitch deck, address any concerns surrounding your product/service or its market, and knock the meetings out of the park. Now each investor has presented you with a document outlining the basic agreements and conditions under which an investment will be made, but you don’t know how to read it or what any of the terms mean. Liquidation preference? Convertible notes? Redemption rights? Unfortunately, this scenario can happen more times than is necessary. Founders who can interpret these documents, called Term Sheets, have a significant advantage over founders who can’t when it comes to how much of their company to give away and what they’re getting in return. It actually pays not to have a basic understanding.

Term sheets can be easy to understand at a high level, but when it comes down to analyzing them, the devil is in the details. The first thing to note about Term Sheets is that they are not legally binding. They are more of an understanding between parties while the final paperwork gets drafted and due diligence is done. Now there are some concepts like exclusivity and confidentiality that are binding, but everything is else fair game to change. Exclusivity refers to the agreement that the founder will not shop the term sheet around to other investors to get a better deal, while confidentiality means that the founders cannot disclose the terms on the term sheet to anybody outside those involved in the negotiations without the investors’ consent. This is how founders and investors can act on the basis of good faith.

There are a lot of terms that appear on a term sheet that may confuse some people with no prior knowledge. It always helps to gain an understanding of these terms before meeting with investors to raise capital. It is also critical to have a legal advisor/lawyer in your corner who can dissect term sheets as well as a CFO who can attest to whether both sides are getting a fair deal from negotiations. Most investors mean well and are looking to build a long-term relationship while generating a return for their firm, but there it always takes that one person who’s in it solely for the returns. That’s why it will always be well worth it to invest in someone who can read the finer details in a term sheet.

Some items on a term sheet are almost ubiquitous. The following terms lay out a rough idea of what to understand:

• Liquidation Preference
  • Describes the order of who gets paid out first if a liquidation event occurs (company gets acquired or goes public).
  • Usually investors, who often have preferred stock, will be first in line and will have a multiple tied to them (i.e. they will get 1x/2x/3x/Nx the investment they put in)
  • This is also true in the event that the company turns completely around and ends up failing or crashing
• Pre-/Post-Money Valuation
  • Pre-money valuation is how much the startup is worth before investment
  • Post-money valuation is the worth of a company after an investment has been made
  • Post-money valuations require some basic math to help understand how much equity is being given up, how much capital you’re receiving, etc.
• Equity
  • Equity on a term sheet refers to what percentage of your company you’re willing to give up to receive capital from investors
• Option Pools
  • Usually an amount of common stock reserved for employees and other members of the company
  • There are two ways Option Pools can play a factor in the term sheet: including it either in the pre-money valuation or the post-money valuation
  • Pre-money valuations are better for investors because in the case of dilution, it falls upon the founder
• Anti-Dilution Provisions
  • Clause that protects investors from a round of financing where the stock valuation is lower in the next round than in the previous round (“down round”)
• Voting Rights
  • Rights given to shareholders to be able to vote on certain decisions of the company
• Board Rights
  • Rights for an investor to be a part of the Board of Directors
  • Usually only one is given per investor per round
• Preferred vs. Common Stock
  • Investors will usually receive preferred stock over common stock
  • Preferred stock gives investors a greater share of the company’s earnings and are first in line in a liquidation event
  • Common stock is usually handed out to employees and other members of the company and are paid only after the preferred shareholders get their slice
• Convertible Notes
  • Technically considered a type of debt that instantly turns into stock when a founder raises additional rounds of capital
  • Usually much easier and efficient to finance than other methods, and should be done when raising lower amounts of funding

If founders can get a general sense of how each of the above terms play a role in landing additional capital for their company, they will have a major step up during the negotiating phases. A few percentage points can potentially mean giving up millions down the road if not negotiated correctly. It always pays to do your homework and have a set number or goal in mind with Term Sheets. If all else fails, hopefully there’s a good lawyer or CFO in your corner.