Introduction
In today’s highly competitive world, knowing the consequences of entering into specific contracts is important, especially for startups. The right knowledge about them can generate legal hassles for the startup, which would be bad not only for the reputation of the startup but also for its financials.
Term sheets can make or break your deal since they lay the foundation of the venture capital investment relationships and terms between the parties, eventually giving way to the final contract.
Education on term sheets helps to understand the negotiable terms. Not all terms mentioned in the contract are equally important; hence, we must understand which term requires you to negotiate. Confusion in terminology or understanding can impact the negotiations, which must be avoided.
While valuations are an essential part of your business, you must focus on other terms, such as liquidation preferences, indemnification and termination, etc. Therefore, this article shall act as a basic guide towards your understanding of term sheets for startup founders.
What is a term sheet?
A term sheet is a summary of the proposed key terms of an investment in your startup. It is the first official non-binding contract between the startup and its investors. It covers the important aspects of a deal without detailing the small uncertainties eventually covered in the final, binding contract.
For example, when startups initiate fundraising ideas, the terms and conditions related to the investment are detailed in the term sheet. During the raising finance stage, the term sheet is used to negotiate the final conditions, post which a formal legal contract is drafted by a lawyer, which formalizes the agreement between the parties.
If the terms mentioned in the term sheet are not agreeable to either of the parties involved, then they can walk away from the deal. Some common things that must be kept in mind while negotiating a term sheet are:
- Have realistic financials and you have the capabilities to pay back the investments made.
- Ensure that the investors are committed towards the growth of your business.
- Ensure clarity in the term sheet related to what you want and what you are prepared to give up to receive it.
- Avoid over-commitment since it is capable of causing problems in the future.
Therefore, the term sheet balances the interest of both the founders and the investors. A poor term sheet can put the founders and investors at odds with each other, and a well-drafted term sheet can add to the efficiency and comprehensibility of the parties involved.
Term sheets are usually requested only when the parties are close to completing a funding round and wish to formalize the terms before having any additional investor commitments.
Term Sheet’s key terms
Some common factors included within a term sheet are who gets what financially, who can take legal action in future contingencies, valuation of the company, price per share details, and the economic rights of new shares.
Key elements of a Term Sheet
Here are some of the critical elements to be included in your term sheet:
Valuation
This clause allows the investors to ascertain the value of the company and to determine how much they should invest in the company in exchange for the extent of the control they are receiving. Here, take note of both the pre-money and post-money appraisals on the term sheet. While pre-money valuation is the value of the company prior to the investment, post-money valuation is the sum of pre-money valuation and the investment received.
As a startup founder, it is ideal to have a situation where the post-money valuation is neither too high nor too low. Too low valuation would lead to unnecessary dilution of your stake in the company, while too high valuation will increase the performance pressure and might create difficulties for future investment possibilities.
However, determining the valuation of the company at such an earlier stage has its own set of difficulties. Some of the techniques that may be incorporated into the valuation process are:
- Standard Earning Multiple Method. Here, a multiple is the measure of one element of the financial status of a company. Therefore, through this method, the multiple is applied to the company’s earnings. For example, if a company has $1 million in earnings, and has a multiple of 6x, then the valuation of the company would be $6 million. Some common factors that determine the multiple for a business are the revenue trends, the industry the company is a part of, the age of the company, founder involvement, and the liabilities of the company.
- Human Capital Plus Market Value Method. Through this method, we evaluate the team and the overall experience that the company currently has. The founders predict the value of the company by looking at the potential of the workers.
- Exit Method. This method determines the amount of money the investor shall receive today if the company is sold or decides to go public. This type of valuation is capable of giving the investors an idea about what the company would be worth down the line.
- Discounted Cash-Flow Method. Through this method, we estimate the value of an investment by using its expected future cash flows. We analyze the investment made today and predict the returns it can generate in the future.
Option Pools
Option Pools are a block of stocks reserved for the company’s current or future employees. Commonly called ESOPs (Employee Stock Ownership Plans), these plans are used to attract and retain employees in a startup. When you look for investments, the existing option pool is expected to be added to a term sheet. They are mentioned as a percentage of the company’s post-money valuation.
Since ESOPs are a part of the founder’s equity, any increase in the number of ESOPs would mean a greater dilution of the founder’s capital. Therefore, while pre-money option pools benefit the investors more due to the dilution of the founder’s share, the post-money valuations could also result in the inclusion of investors in future dilutions. Hence, post-money option pools are founder-friendly. Despite this, most of the option pools are determined pre-money only.
Liquidation preference
This is one of the essential elements an investor looks into in a term sheet. This acts as a safety net for investors who shall get preferred stock. So, in case the startup fails, the agreed liquidation preferences are capable of giving investors at least some of their money back.
Therefore, when an investor invests money in your startup, the investment is the accepted expression of their liquidation preference. This simply means that the preferred stock investors shall receive their investment backup for their original investment in the company before any common company stakeholders receive their share. However, this would give no returns to the investors in case all the money is lost.
Board of Directors
While this might not seem very important for a startup, this especially becomes predominant with the expansion of the business. This is why a board of directors’ section would be found in all term sheets.
The fairest arrangement is an equal representation of founders and investor-friendly members on the board. Some companies also prefer to include an “independent member” on the board, a member from within the business community. This clause should clarify the details of board representatives nominated by investors.
Investor Rights
This clause is used for the protection of the investors, especially during the early stages of their investment. It is possible for the rights to vary depending on the type of business that the investments are made in, and hence, it is always a good idea to take the guidance of a lawyer to ensure that you enter into a fair bargain.
Some common examples of rights provided to early investors are:
- Anti-dilution rights. This right allows the investors to maintain their ownership percentages in the company, even when new shares are issued. Therefore, there is no decrease in the shareholder’s ownership.
- Pre-emptive or Pro-rata rights. This right allows the investors to invest the company’s later stock prior to anyone else in the company, providing them with an advantage over anyone else.
- Right of first refusal (ROFR). This right allows the investors to get the first choice to buy additional company shares before the shares are offered to someone else. Here, if the investors choose to exercise this right, then the issue price is expected to be the price offered to any third party.
Ownership Percentage of Share Classes
While the board shall make many decisions related to the company of directors, some would require shareholder voting. This clause shall include the share class owner percentages or the percentage of shares each individual or group owns in the company.
Participation Rights
There are two advantages for investors who decide to purchase the participation rights in the company – the early return of the money they invested in the startup and a share of any leftover funds in the company. These rights are mostly popular among investors, considering they can increase their returns on investment. However, the startup founders can try to negotiate for the complete exclusion of these rights.
Dividends
This clause helps in the distribution of profits among the company’s shareholders. The dividends can either be paid in cash or through stocks. These are usually 5% to 15%, which accrue over time. There are two types of dividends in existence:
Cumulative Dividends
These dividends benefit the preferred stockholders/investors at the expense of the holders of common stock (i.e., founders and employees). These are calculated every year. In case the company is unable to pay the cumulative dividends, they are carried forward into the following year, and they continue to grow until they are fully paid to the investors or till the right to dividends is terminated.
Non-cumulative Dividends
In this case, stockholders/investors are not paid any previously omitted or unpaid dividends. Due to this, startup founders prefer these types of dividends, considering that they are under no obligation to make any payments to the shareholders.
Things that should be avoided in a Term Sheet
There are some things that the founders should try to avoid including within the term sheet:
Redemption Rights
These rights allow the investors to ask for their investment back. If the company succeeds or fails after the investment, this clause will not pose any problem since the investor would get their return back in the former case or get anything at all in the latter case. However, redemption rights are capable of imposing problems for the business when the startup is going through a rough patch and if some investor suddenly decides to take out their money.
Milestone-based Financing
Under this type of financing, the parties agree that an initial portion (tranche) of financing shall be followed by another portion. This assumes that the company has hit some milestones. In case the milestones are not achieved by the company, the investor gets the right to change the terms of their deal. In some other situations, founders receive their portion of funding only when the company has reached the milestones.
This clause is not very common in term sheets anymore. Therefore, highlight the same whenever a discussion on this type of financing occurs.
Unnecessary Fees
There are instances when sections of “board fees” or “monitoring fees” are included within the term sheet. In both these cases, the investor ends up charging the founder for their presence in the board meetings or for performing any tasks to monitor their investment. These clauses are unfair, unnecessary, and are capable of upsetting any future investors in the company. Hence, these should be avoided.
Multiple Board Seats per Investor per Round
The customary practice in a company is to provide one board seat per investor per round. Therefore, do not let any investor take undue advantage of having multiple board seats since it can dilute your share in the company and limit future rounds.
Term Sheets: Binding or Non-Binding?
This can be a tricky question, especially because it depends on the language used in the term sheet. While most of the term sheets are non-binding, there are exceptions to this rule. If the language of the term sheet is expressly non-binding, then such a term sheet shall be considered non-binding. However, if the term sheet includes clauses such as “negotiate on good faith”, this is a binding language; hence, it becomes difficult for either of the parties to change their mind and not follow the term sheet.
Conclusion
You must carefully assess and negotiate your term sheet to avoid investor dissatisfaction since the primary stages of negotiation play a pivotal role in your final agreement. It is also capable of furthering the relationship between the parties, depending on the kind of negotiations they engage in.
Before making any final decision, investors would want to know about the kind of control they shall have over the business and how they shall be getting the returns for their investments. Additionally, they would be interested in looking at your business plans, competition, team, experience, and products/services. Therefore, try to give a clear representation to the investor while fulfilling the objective of having maximum control and minimal risks.
LegaMart is capable of providing you with any advice related to term sheets, along with helping you go through the negotiations and reach a valuable investment. Visit the LegaMart directory today to get quotes from lawyers specializing in venture capital investment relationships.
Frequently Asked Questions (FAQs)
What is a term sheet?
A term sheet summarizes the proposed main terms of an investment in your startup. It is the first non-binding contract between the startup and its investors, covering the major aspects without detailing the small uncertainties eventually covered in the final, binding contract.
What are the key elements of a term sheet?
These include:
- Valuation
- Option Pools
- Liquidation Preferences
- Board of Directors
- Investor Rights
- Ownership Percentage of Share Classes
- Participation Rights
- Dividends
