After the hubris of the last couple of years, the funding landscape is going through a bit of a reset so I thought it would be worth revisiting some of the fundamentals that every founder should get their head around, starting with that most coveted of documents...
The Term Sheet
What to look out for in a term sheet is really a question in three parts, what is a term sheet, why is it important and what goes into it.
What is a term sheet?
A term sheet is a non binding document that sets out the key terms that are required for an investment into a company to happen.
It is non binding because it is normally sent subject to various due diligence requests that an investor will make prior to finally committing their capital to the business.
Due diligence may take weeks or months depending on the size of the investment, the nature and stage of the business and the size of the management team.
Once due diligence is completed the process moves forward on to longer form legal documentation.
If it’s non binding, why is it important?
Term sheets are important because on signing, they often give the investor a period of exclusivity in which to carry out their due diligence without the startup seeking other investors.
For the startup, they are a strong indicator that an investor is intending to commit their capital and hence provides an element of certainty that the investment will go ahead.
Be aware, there is no guarantee that this will actually happen, as I said, term sheets are non binding.
As a term sheet is often issued by the lead investor (i.e. the investor that has set the terms of the capital raise), it allows other investors who are providing follow on capital to piggy back off of the due diligence and terms that the lead as set.
What goes into a term sheet?
There are two key parts to a term sheet, those that deal with Economics and those that deal with Control
These are the terms that lots of startups and founders focus on but as we will see, whilst important, the terms that govern control can be just as critical to focus on.
- Investment Amount - This is the amount of capital that the investor is willing to invest in the financing round. It may be less than, the same as or even more than the amount the startup is seeking to raise.
- Price - This is where most founders tend to focus, normally expressed as a ‘pre-money’ valuation, i.e. the value of the business before the new investment monies are taken in. This in turn defines the ownership percentage that the investment gives the investor. For example, if a company is raising $1m which is committed in full by the investor and values the business at $5m pre money, this means that the post money valuation would be $5m pre money valuation + $1m new money = $6m post money valuation and the investor would own 1/6 = 16.7% of the company. If the $5m was set as the post money valuation (i.e. after the investment happened, then the investor would own 1/5 = 20% of the business - this is why it’s very important to understand the difference between pre and post money valuations on the term sheet.
- Liquidation Preferences - These are special terms typically insisted upon by venture capital investors (though not always) which given them the right to get their money back first in the event of a sale or closure of the business. For example, if they have a 1x non participating preference, this would mean that in the event of a sale they could get their original investment back but no more (unless they lose the preference and convert to ordinary / common shares). for example if they invested $1m at $5m pre money and then the business were to immediately sell for $4m, if they just converted their percentage ownership, they would receive 16.7% x $4m = $666.7k, which is a loss on the original investment. By exercising their preference, they get the whole $1m back before other shareholders receive a penny. There are many types of liquidation preferences and it is worth looking at all of them.
- Founder Vesting - Institutional investors (VCs) may well ask for founders’ shares to vest over a period of time in order to avoid the risk that one of them quits and then holds a significant portion of the business. There may be a vesting schedule that governs this, it might look something like this: 25% of shares to vest after first year, then monthly vesting of the remaining 75% over the next 4 years. This effectively means that founders will only own all of their shares after 5 years. There would normally be provisions for accelerated vesting if the company exits.
- Pre-Emption Rights - These rights allow the investor to participate in subsequent funding rounds to maintain their shareholding. For example, if they currently own 10% of the company and a new financing round of $1m at a $4m pre money valuation were to occur, they would be diluted by 20% (1/5 = 20%) leaving their shareholding at 8%. Pre-Emption rights allow them to invest the necessary capital to make up the balance 2%. In this example, if $1m = 20% of the post money capital, then each percentage of dilution is $1m / 20% = $50k / %. To maintain their 10% shareholding, the investor would have to invest a further $100k ($50k x shortfall of 2 percentage points).
- Other - There are other terms that may come into play for example Option Pools, Pay-to-Play rights and Anti-Dilution rights. It is worth taking legal advice to understand how all these terms might impact your startup.
These are the terms that govern the decision making process of the business.
- Board Of Directors - The term sheet will often stipulate how many founders or members of the management team may sit on the board and will likely demand that holders of preference shares get a set number of board seats as well. There is no prescriptive way to structure a board but in a startup anything over 5 members becomes counter productive.
- Reserved Matters - These are the items that require shareholder consent before the management team proceed with them and can include:
- Introduction of Debt
- Creation of new shares
- Exiting the business
- Changes to the articles of incorporation
- Revision of founder salaries
- Information Rights - These dictate what information the investors may receive and the frequency of provision. Typically startups will send monthly or quarterly updates including financial performance, growth metrics, commercial wins and challenges they are facing.
- Tag-Along and Drag-Along Rights - Tag-along rights allow minority shareholders to join majority shareholders should the majority holders sell their shares and drag-along rights force minority shareholders to participate if a majority holder sells their shares - this stops minority shareholders acting together to block a sale.
The reality is that a term sheet may contain any number of nuanced clauses so it is really important to take legal advice when you have one in front of you - the devil is ALWAYS in the detail. Terms can (and should) be negotiated prior to signing, don’t accept the first thing that’s put in front of you.
And remember, a term sheet is just the starting point for a new investor coming in, there is still the due diligence and full legal process to go through, but the good news is that your chances of securing investment with a term sheet in hand is way higher than when you don’t!
Yes! V important to focus on this. Thanks Aarish. Often founders think once the economics (price and valuation) are agreed it’s a done deal. But then the term sheet arrives, or worse just a full set of docs, with all sorts of extras that can really cause problems later on. I’ve seen some horrors from VCs I won’t name. So the term sheet really helps flush out any issues before everyone gets too involved/ dependent on the deal going ahead.
Working on something new.
2 年Thanks Aarish Shah - I find the most surprising term for first time founders is founder vesting. Especially once they have a few years of effort under their belts. The argument from the other side is that the sooner they start their vesting, the sooner it is over. Which is a reasonable position, and true - it's much easier to push back against an extension if you are half way through on the basis that it would be unreasonable than it is to push back against the concept as a whole. The other is restrictive covenants (broadly: non-competes). You can use a shareholders agreement to impose much longer non-compete requirements (into the years) than would be enforceable in an employment contract. In most cases they are part of the 'commercial-terms-cost-of-finance', but people can be a bit caught out (and indeed put out!) by them nonetheless. Great piece!