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Deciphering a Term Sheet

Deciphering Term Sheets - ibuildcompanies.com by Jeanne Heydecker

A term sheet is the document that lays out the terms of an investment and the collateral, be it a patent, licensing deal, a company, or a single product or service. It details what you are giving, and what you are getting in return from the investor. Then it lays out the guidelines of how both parties will act to protect the investment.

Term sheets can vary depending on what type of funding round you are in, and how much is at stake, as well as who is involved. Generally term sheets for seed rounds are going to be much lower and shorter in scope than for series A or beyond. The less at stake, the less complex it should be.

Term sheets can be really scary for new start-up founders. More than anything, it’s the fear of making a mistake that you might regret later as the business grows. Investors are savvy and experienced negotiators, and all the language included in the term sheet is there because it is important to them. Every benefit and protection an investor gets into a term sheet comes with some sort of loss or sacrifice on your part – either in transferring control away from you to the investor or shifting risk from the investor to you. 

You probably have more leverage to get better terms than you think. More and more firms are targeting seed stage companies. This competition makes it harder for investors to dictate terms the way they used to. The key is knowing what to expect, knowing what you want out of the term sheet, knowing what your dealbreakers are, and of course having good representation to review all of the fine print.

Valuation

Having a minimally viable product and perhaps a few paying customers can dramatically change your valuation. Valuation is the most critical component of the term sheet and there are two significant parts: pre- and post investment valuations. For example, if the investors believe the company is worth $2M, and they want to invest $1M, your pre-money valuation is $2M and your post-money valuation is $3M:

Post-money = $2M pre-money + $1M investment

The $1M investment gives investors 33.3% of the company

A poor valuation can ruin a deal even if all other terms are in your favor. However, the inverse isn’t necessarily true. A great valuation doesn’t always outweigh unfavorable terms elsewhere on the term sheet.

But many founders don’t know this. They naively assume that a great valuation equates to a great term sheet. Don’t make that assumption. Investors can extract more value than the valuation would imply, so the best deal may not always be the one with the highest valuation. Plus, you set a bar for yourself with every future term sheet valuation and if you haven’t cleared that bar the next time you need to raise money, you put yourself in a very bad position.

Option Pools

Option pools are the second most critical component. Preferred and common stock are different as well. Preferred stock is typically held by the investors while common stock is held by founders and employees. Option pools are the shares reserved to attract and retain future hires, directors, etc. 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-investment.

Option pools are also a way to lower the company’s effective price since an option pool will typically require you to place a certain amount such as 15% into future options. This effectively brings down the owners’ amount down to 51.7% since 33.3% + 15% = 48.3%. You may want to do a headcount hiring list plan with options along with a list of current employees and a retention plan of their forecasted options to ensure the percentage makes sense to both you and the investor. Then negotiate with the investor to add more money to the pre-money valuation to cover the option pool.

Participation Rights

Participation rights are another huge issue that most founders don’t understand. Participation rights are also known in the industry as “double dipping”. Since investors get preferred stock and not common stock, they get paid first, and the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.

However, the preferred stockholders would then also be treated like common stockholders and would share proportionally in the remaining proceeds –in effect, being paid twice. Issuing participating preferred rights has the same effect as issuing a promissory note and shares of common stock to the investor.

I remember a group of people who were planning to start a firm arguing over who should get what percentage of the firm pre-investment. The most vocal co-founder thought he should get 45% of the company, with the other three cofounders getting between 10 to 15% each. He wasn’t even counting the potential investor percentages, option pools, anything. What he didn’t realize was that most investors will add a clause typically paying them back their investment first before anyone else sees a dime during a bankruptcy. liquidation or sale, sometimes more. You’re still responsible for the debt. You still have to pay your creditors.

Find yourself a good lawyer who has a lot of experience with these types of deals to review your term sheet for your own protection.


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jeanneleez

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