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How do you align incentives on a term sheet for VC and startup founder?

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A term sheet is a document that outlines the key terms and conditions of a venture capital investment in a startup. It is not a legally binding contract, but it sets the stage for the negotiation and due diligence process that leads to the final agreement. As a startup founder or a VC, you want to align your incentives on the term sheet to ensure a fair and mutually beneficial deal. Here are some tips on how to do that.

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Navas Ebin Muhammed

Head of APAC (Managing Director) at Mars Growth Capital and Liquidity Group || Asia’s largest private credit fund for…

1 Understand the valuation

The valuation of the startup is one of the most important and contentious aspects of the term sheet. It determines how much equity the VC will get in exchange for their capital, and how much dilution the founder will face. The valuation can be expressed as a pre-money valuation, which is the value of the startup before the investment, or a post-money valuation, which is the value of the startup after the investment. The pre-money valuation is usually preferred by the founder, as it gives them more control over their ownership stake. The post-money valuation is usually preferred by the VC, as it gives them more clarity over their return potential. To align your incentives on the valuation, you need to understand the market dynamics, the growth prospects, and the risk profile of the startup, and negotiate a valuation that reflects the realistic expectations of both parties.

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2 Choose the right type of financing

The term sheet also specifies the type of financing that the VC will provide to the startup. The most common types are equity financing, where the VC gets shares in the startup, and convertible debt financing, where the VC lends money to the startup that can be converted into equity at a later date. Each type of financing has its own advantages and disadvantages for both parties. Equity financing gives the VC more ownership and influence in the startup, but also exposes them to more downside risk. Convertible debt financing gives the VC more flexibility and protection in case of a downturn, but also limits their upside potential. To align your incentives on the type of financing, you need to consider the stage, the traction, and the capital needs of the startup, and choose a type of financing that matches your risk-reward appetite and your long-term vision.

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Navas Ebin Muhammed

Head of APAC (Managing Director) at Mars Growth Capital and Liquidity Group || Asia’s largest private credit fund for technology startups backed by MUFG || Building Singapore’s tech financing ecosystem
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In the early stages of a startup journey, it is always advisable that startups raise equity capital since it gives the founders the freedom to experiment and build the right products and solutions. As the startup progresses into later stages, it will have more options on the table including raising non-dilutive financing or venture debt alongside equity financing. Also, the equity financing can be structured to meet the risk appetite of the VCs involved. One of the most important things to do as a startup founder is to ensure that you choose the right form of financing for the right reasons and at the right stage. For example, any sort of working capital should be financed with debt and not equity. Debt is also a cheaper option for M&A.

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3 Balance the control rights

The term sheet also defines the control rights that the VC will have over the startup. These include board representation, voting rights, veto rights, information rights, and liquidation preferences. These rights give the VC some degree of oversight and influence over the strategic decisions and operations of the startup, as well as some protection and preference in case of an exit or a liquidation. However, these rights also limit the autonomy and flexibility of the founder, and can create conflicts and frictions if not aligned with the interests and goals of the startup. To align your incentives on the control rights, you need to balance the level of involvement and intervention that the VC will have in the startup, and ensure that the rights are fair, reasonable, and aligned with the best interests of the startup.

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4 Align the exit strategy

The term sheet also outlines the exit strategy that the VC and the founder have for the startup. The exit strategy is the way that the VC and the founder plan to realize their returns from the investment, usually by selling the startup to another company or going public. The exit strategy affects the valuation, the type of financing, and the control rights of the term sheet, as well as the growth strategy, the culture, and the vision of the startup. The exit strategy can vary depending on the preferences, expectations, and objectives of the VC and the founder. Some VCs may prefer a quick and profitable exit, while others may prefer a longer and more sustainable exit. Some founders may want to retain control and independence, while others may want to maximize value and impact. To align your incentives on the exit strategy, you need to communicate and agree on the timing, the valuation, and the conditions of the exit, and ensure that they are compatible with the growth and development of the startup.

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5 Build trust and rapport

The term sheet is not only a document, but also a relationship. It is the foundation of the partnership between the VC and the founder, which can last for years and have a significant impact on the success and failure of the startup. Therefore, it is crucial to build trust and rapport between the parties, and avoid any misunderstandings, misalignments, or mistrust that can jeopardize the deal or the relationship. To align your incentives on the term sheet, you need to be transparent, honest, and respectful with each other, and address any issues or concerns that may arise during the negotiation and due diligence process. You also need to be flexible, collaborative, and constructive, and seek to create value and synergy for both sides.

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Navas Ebin Muhammed

Head of APAC (Managing Director) at Mars Growth Capital and Liquidity Group || Asia’s largest private credit fund for technology startups backed by MUFG || Building Singapore’s tech financing ecosystem
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As a startup founder, you need to be aware of what you want out of the term sheet and it needs to be communicated to the VC.As a VC, you are always trying to come up with something that balances the expectations of the founders, the return expectations of your LPs and the risk appetite of your IC. It is imperative that a VC communicates their inability to offer terms that a company expects at a certain stage in a clear manner and with reasons.There could be a multitude of reasons why they can’t make a certain offer or why they can only offer something that’s not what the company asked for.The most important thing in such a scenario is to be transparent and to list your reasons in the best way possible.This can lead to constructive dialogue.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you align incentives on a term sheet for VC and startup founder?

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6

1 Understand the valuation

2 Choose the right type of financing

3 Balance the control rights

4 Align the exit strategy

5 Build trust and rapport

6 Here’s what else to consider

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How do you align incentives on a term sheet for VC and startup founder?

1

2

3

4

5

6

1 Understand the valuation

2 Choose the right type of financing

3 Balance the control rights

4 Align the exit strategy

5 Build trust and rapport

6 Here’s what else to consider

Venture Capital

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