A term sheet is a document that outlines the key terms and conditions of a venture capital investment. It is not a binding contract, but rather a basis for further negotiation and due diligence. Choosing the right terms for a term sheet can make a big difference in the success and sustainability of your startup. Here are some tips on how to do it.
One of the most important and contentious terms in a term sheet is the valuation of your company. This determines how much equity you are giving up to the investors and how much dilution you are facing. Valuation is not an exact science, but rather a function of market conditions, competitive landscape, traction, growth potential, and negotiation skills. You should do your homework and research comparable deals, use multiple methods to estimate your value, and be realistic and flexible.
Honestly, "valuation" is often a misleading term. Each deal should prioritize values over valuation. Chasing valuations, many founders overlook crucial discussions about board seats, liquidity preferences, and more, leading to significant missteps
The only valuation that matters is the exit value! Good valuation discussions shouldnt be founders v investors, it should be everyone working together to qork out the best value that 1. Maintains a decent ownership for founders 2. Attracts strong investors and 3. (Sometimes forgotton) allows space to raise future rounds with strong growth but still attractive entry points for new investors
Pre-Money valuation is a very critical driver for a fundraising round. It consists on the calculation of the equity value of the company done with a mix of methods both quantitative and qualitative. Early stage startups have to leverage more on qualitative methods (i.e. Venture Capital Method, Berkus, Benchmark, etc.). On Series A+ rounds it is possible to use also DCF and other methods based on financial results.
You cannot ever "know your valuation" at the early stages. This is completely defined by what you negotiate with your lead investor. That being said, this is a simplified way to find a range in which you can negotitate your valuation from: Post-money Valuation = [$ amount raised] x (1/[dillution %]) Pre-money Valuation = Post-money Valuation - [$ amount raised]. Then you can solve for how much you are raising and how much % you are willing to give away in dilution, to find the range of your valuation to negotiate. As a general rule, its usually anywhere from 15-30% dillution per round.
Many founders due to newness of the task leave the question of valuation on the investor /VC. Advice given is also on similar lines wherein Founders need to focus on only how much they need and how they would spend the funds. This is not a bad advice. But satisfaction will come only when founders also understand the art of investment. Only way to gain that understanding is by talking multiple folks in the ecosystem. That's the only way , both parties will come out of that negotiation feeling as win-win.
Another key aspect of choosing the right terms for a term sheet is understanding the trade-offs between different types of terms. Some terms are economic, meaning they affect the distribution of returns among the parties, such as valuation, liquidation preference, dividends, and anti-dilution. Other terms are control, meaning they affect the decision-making power and rights of the parties, such as board seats, voting rights, veto rights, and drag-along. Generally, the more economic terms you concede, the less control terms you should accept, and vice versa.
This is why its so important to have a great lawyer at hand. They can tell you the proper trade-off for each terms and the differences between economic and controlling terms.
Not all terms in a term sheet are equally important or relevant for your situation. You should prioritize the terms that are essential for your vision, strategy, and goals, and be willing to compromise on the ones that are less critical or negotiable. For example, if you are planning to raise more rounds of funding in the future, you should pay attention to the terms that affect your future financing options, such as option pool, conversion rights, and pro rata rights. If you are aiming for an exit, you should focus on the terms that affect your exit scenarios, such as liquidation preference, drag-along, and redemption.
As a rule of thumb, founders will care more about valuation, founder vesting and control terms. An investors will care more about valuation, control and exit terms. You have to know what the other person cares about more (e.g. investors care a lot about drag, board rights etc.), what they won't budge on, and then also what they would budge on. Only then can you know what to prioritize and what is a non-negotiable for you.
Furthermore not all terms are there to be executed. Sometimes for investors it makes sense to include stricter protective provisions at early stage deals, not to really use them, but to leverage them in follow-on negotiations with new investors.
Choosing the right terms for a term sheet is not only about maximizing your own interests, but also about finding alignment and trust with your potential investors. You should seek investors who share your vision, values, and expectations, and who can add value to your business beyond money. You should also be transparent and honest about your strengths, weaknesses, opportunities, and risks, and avoid surprises or conflicts later on. A term sheet is the start of a long-term relationship, so you should aim for a win-win outcome that benefits both sides.
Most pre-seed / seed rounds are now being done on a SAFE, where the negotiations are quite limited. You are only negotiating three pieces - amount of money raised, a Post-Money Valuation and a discount rate. For Series A rounds and beyond (or any priced rounds), there is more negotiation but the most important advice for founders is to have experienced counsel helping to evaluate terms and to know what is market. For Pre-Seed & Seed rounds, 10-30% dilution is most common, so if you are giving up too much of your business that is a red flag, and if you are raising at too high of a valuation you need to make sure you can grow into that in the future. Ask other founders and investors how these rounds are normally structured when in doubt.
It's critical to truly be aligned on a philosophical level with regards to how quickly and aggressively you want to build the business and what trade-offs you will be OK with in order to make that a reality. For example, taking seed stage capital from a massive multi-stage firm with seasoned partners who only want to go for 100x is very different from taking capital from an emerging pre-seed fund who can get to real capital returned to their LPs with even a moderate exit. Understanding your investors expectations (and what they promised their LPs) is critical.
Finally, choosing the right terms for a term sheet requires effective negotiation skills and tactics. You should prepare well, know your BATNA (best alternative to a negotiated agreement), and have a clear walk-away point. You should also be respectful, courteous, and professional, and avoid being too aggressive or defensive. You should communicate clearly, listen actively, and address any concerns or objections. You should also be flexible and creative, and explore different options and scenarios. Negotiation is an art, not a war, so you should strive for a fair and reasonable deal that satisfies both parties.
You have to remember that every legal clause you put into your company will have knock-on effects. You have to think long-term if what you put in there will cause negativity in the long-run. This can be things such as preference shares, board rights, founder vesting etc.
Although it is important to focus on the fundamentals such as your valuation, vesting and control it is also important that you may include measures that provide safety for the future. One way you may do this is through anti-dilution provisions. This may allow you to protect your investment in future down rounds.
Any fundraise trades off three things: 1) amount raised and runway provided 2) dilutive cost and 3) price hurdle. Generally dilution remains the constant, so consider the monthly burn you’ll require multiplied by 24 months, and that should be your target fundraise. That amount divided by roughly 20% dilution will imply your post money valuation. Most people think you start with valuation. In reality you start with how much money and time it will take to de-risk your business, dilutive cost is generally constant based on necessary investor skin in the game, and valuation is the output. Make sure you can 2-3x your post money on the runway you have. If you can’t see that path, raise less and lower your price, knowing dilution is the constant.
The variable in the valuation equation that should demand the lion’s share of mental bandwidth is the monthly burn required to hit a 3x+ step-up in the next round. Unfortunately, it gets far too little genuine thought, and becomes a financial games exercise, instead of what it is — a business exercise with cost of capital as only one of the considerations. This results in a) too little capital raised, due to fear of the dilution, followed by a typically much more expensive bridge round, or b) too much capital raised at either an unnecessarily high cost of capital, or at a valuation which is almost impossible to beat by 3x, often resulting in an expensive down round, not too infrequently with new leadership at the helm of the company.