Understanding Term Sheets: A Guide for Angel Investors

As an angel investor, term sheets are crucial for structuring investment deals and protecting your interests. A term sheet is a non-binding document that outlines the key terms and conditions of an investment, serving as a starting point for negotiations between the startup and the investor.

When an angel investor decides to invest in a startup through Lokal Capital, typically, one of the first documents they encounter is the term sheet. This document outlines the key terms and conditions of the investment and serves as the foundation for the legal agreements that follow. Understanding the components of a term sheet and knowing what to negotiate is crucial for any investor. This guide will walk you through the essential elements of a term sheet and provide tips for negotiating favourable terms.

Breakdown of Term Sheet Components

1. Equity Terms

Equity terms define the type and amount of ownership the investor receives in exchange for their investment. The most common types of equity are common shares and preferred shares.

• Common Shares: These are the standard shares that all shareholders hold, typically without special rights or privileges.
• Preferred Shares: These shares provide additional rights, such as priority in receiving dividends and proceeds in a liquidation event. Preferred shares often come with specific provisions that protect the investor's interests.

The ownership percentage, or equity stake, is calculated based on the company's valuation and invested amount. This percentage determines the investor's influence on company decisions and their share of future profits.

2. Valuation

Valuation is a critical aspect of the term sheet that determines the price of the purchased equity. There are two types of valuation:

• Pre-Money Valuation: The company's valuation before the new investment is added.
• Post-Money Valuation: The company's valuation after the investment is included.

Understanding the difference between these valuations is essential as they impact the investor's equity stake. For example, if a company has a pre-money valuation of $5 million and an investor puts in $1 million, the post-money valuation becomes $6 million. The investor would then own approximately 16.67% of the company ($1 million / $6 million).

Negotiating a fair valuation is crucial as it affects the potential return on investment. Investors should consider the company's growth prospects, industry standards, and comparable deals when negotiating valuation.

3. Liquidation Preference

Liquidation preference determines the order in which investors are paid in the event of a liquidation, such as a sale or bankruptcy. It specifies the amount investors will receive before common shareholders are paid.

• Participating Preference: Investors receive their initial investment plus a share of the remaining proceeds, similar to common shareholders.
• Non-Participating Preference: Investors choose between receiving their investment back or converting their shares into common stock and participating pro-rata with common shareholders.

Liquidation preference is vital for protecting an investor's capital, especially in scenarios where the company's sale price may not be significantly higher than the invested capital.

4. Anti-Dilution Provisions

Anti-dilution provisions protect investors from dilution of their equity stake in subsequent funding rounds. These provisions adjust the conversion rate of preferred shares into common shares if new shares are issued at a lower price than the investor initially paid.

• Full Ratchet: Adjusts the conversion price to the price of the new issuance, providing maximum protection.
• Weighted Average: Offers a more moderate adjustment based on the size and price of the new issuance relative to the existing shares.

These provisions are crucial for maintaining the value of an investor's stake in the company.

5. Other Key Terms

• Voting Rights: Determine the investor's ability to influence company decisions. Preferred shareholders often have specific voting rights on critical matters.
• Board Representation: Investors may negotiate for a seat on the company's board of directors, providing a direct voice in company governance.
• Protective Provisions: Clauses that require investor consent for significant actions, such as issuing new shares, taking on debt, or changing the company’s business model.
• Dividend Rights: Detail how and when dividends are distributed to shareholders.
• Conversion Rights: Specify the conditions under which preferred shares convert to common shares, often linked to specific events like an IPO or acquisition.

Negotiating Term Sheets

1. Identifying Priorities

Before entering negotiations, investors should identify their priorities. This involves determining what aspects of the term sheet are most critical to their investment strategy, such as the level of control, protection against dilution, or specific financial returns.

2. Common Negotiation Points

Some common points of negotiation in a term sheet include:

• Valuation and Equity Stake: Ensuring the valuation aligns with the investor's assessment of the company's worth and securing a significant equity stake.
• Liquidation Preference: Negotiating favourable terms for recovering the initial investment and securing additional upside.
• Anti-Dilution Protections: Striking a balance between protecting the investor's equity and allowing the company flexibility to raise future capital.

3. Strategies for Effective Negotiation

• Building a Strong Case: Investors should use market data, comparable deals, and thorough due diligence to support their negotiation points.
• Engaging Legal and Financial Advisors: Professional advisors can provide valuable insights and ensure that the investor's interests are protected legally and financially.
• Maintaining a Collaborative Approach: A positive relationship with the founders and other stakeholders can lead to more productive negotiations and a stronger partnership.

Conclusion

Understanding and negotiating term sheets are essential skills for angel investors. By focusing on key components such as equity terms, valuation, liquidation preference, and anti-dilution provisions, investors can secure terms that align with their investment goals and risk tolerance. Engaging in thoughtful negotiation and seeking professional guidance can help ensure a successful and mutually beneficial investment.