Founder resources- Demystifying term sheets

Many first time founders get confused at the sight of a term sheet. While it is always advisable to hire a CA or Lawyer to help you draft and understand legal documents, it is critical for a founder to understand the language of startup funding. 

In this post we look at the demystifying term sheets-

Term sheet

Term sheets are important negotiating instruments where terms between the founder and investor are set up, and which form the basis for drafting the final shareholder and share subscription agreement. Term sheets are legally non-binding (not legally enforceable), and are used as a letter of intent. In all cases, the shareholder agreements (enforceable by law) supersede term sheets.

Funding round

This is the first external funding for your startup which usually comes from your friends and family. This round is the F&F round. The next round comes from investors which is usually the Seed or Angel round. Later, as your startup grows and if you require more funding- you raise money from professional venture capital investors- Series A round, then Series B and so on.

FYI, Flipkart had approximately 22 funding rounds before being acquired.

Valuation

While the value of a company is the estimated present value of all future cash flows, it is not the same for a startup. A startup is too young to have any formula attached for financial valuation. Hence, for a startup, valuation is mostly to answer a question of how much money does the startup need, and what stake is the founder ready to dilute.

For eg- If a startup needs 1 cr of cash, and the founder is ready to dilute 10% of his stake, then the valuation would be 10 cr.

Cap table

Cap table or capitalization table shows the stake ownerships of founders and every investor in the startup.

Dilution

Every time new funds are to be raised in a startup, the cap table changes and ownership of the stakes of all existing investors are diluted. 

Pro-rata rights

Pro-rata rights give an investor the right but not the obligation to participate in future rounds of funding to maintain their present stake.

Anti-dilution rights

Anti-dilution rights protect the investor in case of a follow on round that is lesser in valuation than the previous round.

Liquidation preference

Liquidation preference helps understand who gets paid first in case the company gets liquidated. Usually investors ask for higher 1x liquidation preference or pro-rata liquidation monies. If an investor asks for more than 1x liquidation preference, it generally is a red flag and the founder should probe it further. You do not want an investor on the cap table that only wants to make money, even in a sinking ship.

Drag along rights

Drag along rights means that if majority shareholders are selling their stakes, then minority investors will also have to follow suit.

Tag along rights

Tag along rights mean that minority investors can exercise and sell their stake if the majority shareholder is selling theirs.

Right of first refusal

The right of first refusal (ROFR) provides non-selling shareholders the right to accept or refuse an offer by a selling shareholder once the selling shareholder gets an offer from a third-party. The non-selling shareholders receive the selling shareholder’s offer on the same terms as presented by the third-party buyer. This right allows non-selling shareholders to control the process of adding a new shareholder while preserving liquidity for the selling shareholder.

Right of first offer

A less known but similarly useful mechanism in the context of a shareholder agreement is a right of first offer (ROFO). A ROFO provides non-selling shareholders with the right to be offered the shares before any external solicitation takes place. If the offer is refused by the non-selling shareholders, only then may the selling shareholder solicit third-party offers on the same terms that were presented to the non-selling shareholders. Thus, a ROFO achieves the same aim as a ROFR: it allows non-selling shareholders to control the process of adding a new shareholder, while preserving liquidity.

Exit rights

Exit rights mean that the founders will make ‘reasonable’ efforts to provide an exit to investors within a pre-specified period of time defined in the term sheet. Exit periods, depending on the investor (VC fund or Angel investors) can be anywhere between 5-8 years. This is because most funds operate in a finite time frame to return money back to the fund's investors. However, founders should note that any period less than 3-5 years raises a red flag.