What is the best way to structure a term sheet for VC alignment?

The practice of valuing any deal typically always starts with benchmarking analysis and market comparables - studying precedent by researching recent deals in similar industries and stages of development. Next, when considering the dilution effect of an investment, the ownership structure must align with the long-term interests of both parties. The term sheet should clearly outline the equity ownership percentages for the founder(s) and VC. Aligning incentives for the founder(s) and VC ensures that both are working towards the ultimate goal of maximizing value across stakeholders.

In my experience, providing a range of valuation subjected to due diligence helps promoters and other investors to make preparations accordingly. Investors and promoters can negotiate and structure the deal that does not impact the valuation of the company on one hand while reducing the cost of acquiring equity for the investors.

Clearly outline the pre-money and post-money valuation of the company. This is a fundamental aspect of the term sheet and directly influences the ownership stake that the VC will have in the startup. Consider including anti-dilution protection mechanisms to protect the investor's ownership stake in the event of future down rounds. This is typically expressed as either full ratchet or weighted average anti-dilution.

When it comes to structuring a term sheet for VC alignment, one effective approach is to prioritize clarity and transparency. Start by outlining key terms such as valuation, investment amount, and ownership stake in a clear and concise manner. Additionally, incorporating provisions for governance rights, such as board seats and decision-making processes, can help ensure alignment of interests between founders and investors. Lastly, don't forget to include provisions for potential future financing rounds and exit scenarios to set the stage for long-term alignment.

DCF (Discounted Cash Flow) valuations are more fitting for established companies with predictable cash flows and clear growth trajectories, allowing for precise future earnings forecasts. They suit industries like utilities or consumer goods, where revenue streams are stable and growth rates are consistent. Multiples-based valuations shine in high-growth, dynamic sectors like technology or biotech, where future cash flows are uncertain and comparables provide a better market context. They're also useful for early-stage startups where cash flow predictions are less reliable, leveraging industry norms to gauge value. Post-money valuation clarity benefits all by defining exact equity stakes post-investment.

Control & governance are difficult because they must strike a balance for the founder and investor. VC investors, who are buying a minority position in a company, must understand they can't expect to control every decision the company makes. Additionally, the founder must understand that as a fiduciary to their LPs an investor needs proper protections in place to ensure their dollars are stewarded as promised. Governance should be viewed as a positive thing, founders should structure their board in a balanced way with people who can add value to the business (strategic insight, customer intros, fundraising support). A track record of proper governance will benefit the company with short term results and with future investors / acquirers.

There are crucial differences between American & European board governance. American boards (1-tier) are actively involvement in strategic decision-making & management. European boards (2-tier) are typically supervisory bodies focusing on oversight and compliance. The board is composed of founder reps, investor reps, and external experts. Minor investors can have observer seats. Board members are appointed & dismissed by the shareholders. Too much governance can be a burden. There is a balance between keeping the board satisfied vs delivering business growth given the limited resources of a start-up.

Trick stuff: The board of directors should be structured to provide appropriate representation for both the investors and the entrepreneurs. This could involve having a balanced board with both investor and entrepreneur representatives, as well as independent directors who can provide objective advice and oversight. And the term sheet should include provisions for governance that ensure transparency, accountability, and fairness. This could involve provisions for regular financial reporting, shareholder meetings, and other governance mechanisms.

Address the issue of board representation. Specify the number of seats the VC will have on the board and whether they will have observer rights. Board representation is crucial for investors to actively participate in key decisions.

Define clear governance structures that allow for investor input without stifling founder control. Include board composition, voting rights, and decision-making thresholds. Ensure a balance that allows investors to protect their interests, especially in major decisions, while founders maintain operational control.

A term sheet for VC alignment should balance interests through a fair valuation, choice of securities (equity/convertible), and a 1x non-participating liquidation preference. Governance requires balanced board representation. It should include protective provisions, pro-rata rights, a founder vesting schedule, drag-along rights for exits, and broad-based anti-dilution protection.

Define the liquidation preference terms, which determine the order in which investors and other stakeholders receive proceeds in the event of a sale or liquidation. This can significantly impact the returns for investors.

Startups must be wary of onerous liquidation preferences that can disproportionately favor VCs at exit, potentially leaving little for founders and early investors, especially in lower-than-anticipated exit scenarios. A preference multiple beyond 1x can diminish non-preferred shareholders' returns, while participating preferences may allow VCs to double-dip, receiving their preference and then sharing remaining proceeds. To safeguard interests, startups should aim for a 1x non-participating preference, ensuring a fairer distribution upon exit. Negotiating clear, equitable terms around liquidation preferences is crucial to maintaining alignment and ensuring that all parties are adequately incentivized for the venture's success.

Liquidation preference ensures investors recoup their investment before other shareholders in a sale. A 1x non-participating preference is standard, fair to both sides. Dividends, often cumulative and payable upon liquidity events, can be negotiated but are less common in early-stage startups.

Investors must scrutinize anti-dilution clauses, ensuring protection against share value dilution in down rounds. Opting for weighted average over full ratchet mechanisms can offer a balanced approach, preventing excessive dilution for existing stakeholders. Conversion clauses need clear terms for preferred-to-common share conversion, vital for exit participation or voting. Balanced anti-dilution and conversion terms protect investor interests without overly penalizing founders, maintaining startup-investor alignment and incentivizing sustained growth.

Anti-dilution provisions protect investors from future equity dilution by adjusting their share price in the event of a down round. A broad-based weighted average is equitable. Conversion terms should clearly state conditions under which preferred shares convert to common, typically during an IPO or sale, aligning interests for an exit.

In my experience, most option pools for early stage companies start at around 20% and vest over a two-to-four-year period (usually four years). When a company is just getting started, incentivizing key hires with equity is a great way to gain early alignment and preserve working capital. I've also seen option pools increase at subsequent financing events to ensure the company is able to attract key talent in the future. When this occurs, existing equity holders are diluted, but in the long-run it's worth it. Earning equity in a startup is attractive because of the unlimited upside potential if the company succeeds. The downside is that equity value can take a long time to grow and it's difficult to transfer or sell to an outside party.

We observe employee stock options pools ranging from say 5% to 20%. ESOP shares are usually granted to key employees, occasionally extending to all employees, to align their interests with company objectives. Allocations should be well justified. ESOP shares typically come with a vesting period, typically four years including a one-year cliff and monthly vesting over the subsequent three years. Flavours include virtual (VSOP) vs real shares (ESOP), borne solely by founders vs borne by all shareholders. Options pools can also serve as a mechanism to boost founder shares after they have been disproportionately diluted, providing incentives to retain their commitment.

The term sheet should include vesting provisions to align the interests of the entrepreneurs and the investors. Obviously. This could involve vesting of founders' shares over time to ensure that the entrepreneurs are committed to the company for the long term, as well as vesting of employee stock options to incentivize employee retention and performance.

An option pool is allocated for future employees, affecting pre-money valuation and dilution. Create a pool size that attracts talent but is fair to existing stakeholders. Implement vesting schedules (commonly four years with a one-year cliff) to ensure long-term alignment and performance.

Ensure your term sheet is succinct and leverages standard terms common in future rounds. Strive for modifications in economic terms that benefit all stakeholders evenly. Though innovative terms may provide immediate gains, embracing standard and straightforward terms fosters a more sustainable venture partnership over the long haul. Clever term structuring might seem advantageous initially, but remember, this asset class thrives on long-term growth. Thus, it's crucial to set terms that avoid creating disproportionate advantages and instead, focus on reinforcing the foundational venture partnership all the way through to an autonomous exit.

The term sheet should include provisions for termination that protect the interests of both the investors and the entrepreneurs. This could involve provisions for termination in the event of a material breach of the agreement, a failure to meet performance milestones, or other specified events.