Term Sheet Tips - Critical terms to consider

A term sheet is the document that outlines key financial and other terms of a proposed investment between a founder and an inventor. Terms sheets are also referred to as a “letter of intent”, “memorandum of understanding” or an “agreement in principal.” It’s the first step to facilitating a funding round.

Knowing how to negotiate the technicalities of term sheet is an important skill. This list is not exhaustive, but should give you an idea on the most critical items to consider.

Valuation:?What a business is worth now vs what it will be worth in the future is very subjective. If you have comparables (i.e., how similar companies have been valued) use that information to negotiate with your investors. By way of example, if you give 20% of your company in exchange for $500K, our investors are expecting a return of $15M. Do your numbers support that? If not, you may want to ask for less money or provide a greater equity percentage.

Exclusivity: Investors need time to review your documents and if you are shopping your deal around to multiple inventors, they may not be as committed to performing due diligence when they could lose the opportunity to a competing firm. Exclusivity terms that prevent you from talking to another investor are quite common in term sheets. Anything between 45-60 days is reasonable.

Anti-dilution:?Most term sheets have anti-dilution provisions in the term sheet. If your term sheet includes a ?“broad based weighted average” anti-dilution clause, then move on. If you find a “full-ratchet” anti-dilution clause, then talk to your attorney.

Liquidation Preference:?The liquidation preference determines how much an investor gets in case of a sale of the company; this could have a significant impact on the founder’s return. Later rounds (such as Series B, C and so on) usually carry over the terms from the earlier funding rounds so, it’s important to get this right at the start.

Founder Vesting:?Founder vesting is an important aspect of the term sheet that many founders fail to understand. Investors don’t want to see a fully vested founder leave the company within thirty (30) days of funding and hang on to their shares. 2-3 years is an acceptable vesting period which can be accelerated in the event of a sale of the company.

Tag-along rights: Also known as “co-sell rights,” these allow preferred shareholders who own a minority stake in your company to sell alongside a majority owner, which can result in significant equity gain by a third party. Say an investor owns 20% equity and the founder sells 20% of their shares, under full tag-along rights, the investor can sell all its equity, However, they have a “proportionate tag”, investors can only sell an amount that is proportionate to their shareholding.

Classes of Stock: There are two broad classes of stock commonly referred to as (i) Common Stock and (ii) Preferred Stock. Common stock is held by the founders, employees, consultants and other service providers, and generally has one vote for each share. Preferred Stock is issued to investors and will generally have one vote for every one share initially, but it also comes with a bundle of other rights, privileges and preferences.

Voting Rights: ?Voting and control rights you attach to the Preferred Stock include terms that require investor approval such as, spending above a fixed limit, selling the company, or changing the size of the board. It might also contain a “drag along” provision, which may require founders and major shareholders to vote in favor of a “change of control” (usually a merger or sale of the company) if the board of directors and a certain percentage of the stockholders vote in favor of the transaction in spite of the founders’ objections.

Consulting an attorney can help you to navigate complex term sheets and close finance rounds that preserve important rights for your startup and for future rounds.