How can you design a term sheet to ensure fairness for both parties?

Valuation is not just a number—it's a reflection of a company's potential, market dynamics, and investor confidence. It's crucial to strike a balance between a startup's need for capital and the investor's need for a return on investment. In the current climate, where we see high valuations & significant capital availability, founders should be mindful of potential future down rounds. A fair term sheet aligns long-term interests and sets the stage for sustainable growth, considering not only financial metrics but also strategic value and partnership potential. We recommend not diluting beyond 20% in any round, especially in early stages, to avoid substantially lopsided cap tables. It is also common to have anti-dilution protection.

Actually, most terms sheets are not legally binding. They are indicative. So this article is set up slightly incorrectly. The best thing any founder can do is use a very experienced startup transaction lawyer, and ask them to use industry-standard template documents as the baseline. Valuation can then be determined through market comparisons and by finding a great lead investor to negotiate with and set the rest of the terms. Most early-stage venture rounds will cause 10-25% dilution.

Typically only the lead investor would be given special rights for governance, and that's ~1 board seat for each 20% of ownerships. This varies wildly, but early stage startups should remain majority founder-governed.

Milestones and contingencies in a term sheet serve as a risk mitigation strategy, aligning investor protection with startup growth objectives. It's crucial to balance ambition with realism in these clauses to avoid overburdening the startup, which could stifle innovation and growth. Additionally, incorporating flexibility allows both parties to navigate the unpredictable nature of startup scaling, where pivots and market shifts are common. This approach fosters a partnership mentality rather than a purely transactional relationship, which is vital for long-term success.

The best term sheets do not have milestones or contingencies. Founders should always negotiate for a clean investment round with a clear settlement date immediately after binding docs are signed.

Early stage term sheets with angel investors may not have any special exit or liquidity terms. If the terms are with a fund manager, then those liquidity preferences should be as simple as possible.

My terms sheet structure is simple: - Financing structure and share of co-investors: I usually lead or co-lead the funding round, and I'll specify how much I'm investing and the terms. - Option pool: This is a key component. I like to maximize the unallocated ESOP to give the company more flexibility. - Closing terms and timeline: cover everything from legal and IP issues to technical, team, and commercial DD. - Agreement elements: like company decision making, pre-emption rights, RoFR & co-sale clauses, drag along provisions, and any restrictive covenants. - Miscellaneous matters: We'll discuss expenses, exclusivity, and confidentiality and set an expiration date for the agreement. No confusing jargon here!

Some termsheets will not contain a set valuation but will instead link the entire or part of the valustion to a future event, such as the valuation a future investor offers or a revenue target. Examples of this are: 1. An investment made now, but valuation determined based on the next round with a 25% discount to it. This is known as a convertible note. Sometimes such convertible notes will contain a valuation cap, which means that for purposes of determining the price of conversion and its linked discount, the valuation cannot exceed the cap even if the next round is priced higher. 2. An investment made now, but no valuation set, instead valuation is based on a revenue milestone achieved at the end of a set period such as 6 months.

Crafting a fair term sheet in venture capital is a strategic endeavor that requires a nuanced approach. Start with a realistic valuation & equitable equity distribution. Introduce a vesting schedule to align long-term interests. Liquidation preferences should be fair, ensuring both parties benefit during exits. Balance the board composition to give voice to both stakeholders. Include anti-dilution provisions to protect early investors, but keep it founder-friendly. Detail exit strategies upfront to set the stage for a successful finale. Finally, employ milestones and KPIs to objectively measure progress. A well-designed term sheet sets the foundation for a mutually beneficial relationship, driving success for both investors & entrepreneurs