As an entrepreneur seeking funding for your startup, you’ve likely seen a term sheet. If you have, then you’ll know that they hold a lot of information, much of which can be complex and overwhelming. And if you don’t have much experience with the matter, knowing which terms to really home in on can be difficult.
First and foremost, we strongly recommend seeking legal counsel to guide you through the process. But to help put things in context so you can focus on the big picture, we’ve compiled a very broad look at some of the terms that can have the most significant impact on your business.
What is a Term Sheet?
A term sheet is an agreement that lays out the terms and conditions by which an investment will be made. They primarily cover 1) who controls the company and 2) who receives how much in the event of an exit. Term sheets are (typically) nonbinding, but once agreed upon by the parties involved, the terms set within it are used to draft a more detailed binding agreement.
A standard term sheet will include things like the valuation of your business, the price per share, investor rights, and more. We’ll be taking a look at some of the terms you should pay especially close attention to so that you know where to negotiate. Note that many terms, such as valuation, are subject to change throughout the lifecycle of your business.
Terms Worth Negotiating
Valuation is undoubtedly the most significant item of the term sheet, as it has the largest impact on percentage of ownership and how much each investor receives in an exit. There are two ways to express valuation: pre-money and post-money. Pre-money valuation is the company’s value before the new investment, and post-money valuation is the company’s value after the new investment.
When it comes to valuations, bigger isn’t always better. Although you may get a high valuation, know that a high valuation may not necessarily counteract other detrimental terms. And while a flat round (raising money at your last valuation) isn’t ideal, it’s more favorable than a down round (raising money below your last valuation.
When negotiating valuation, a major thing to keep your eye on the option pool. If an investor wants to add the option pool to a pre-money valuation, it can significantly decrease your valuation. The benefits of including the option pool in your pre-money valuation are threefold for investors:
- This only dilutes previous shareholders. If the option pool was included in the post-money valuation, it would dilute both the previous and new shareholders proportionally.
- Although the option pool is expressed as a percentage of the post-money, valuation, it is allocated from the pre-money valuation, which means it takes more than you’d expect at face value.
- If you exit before a Series B round, for example, all un-issued and un-vested options will be canceled, in a sort of reverse dilution. Basically, this means that some of your pre-money valuation will go to your investors.
Board of Directors
As the Board of Directors can play a massive role in corporate governance, the makeup matters. Ideally, for an early-stage board, the representation of investors and common stockholders should be proportional to their control of the cap table. A common example would be a three-person board consisting of two founders representing common stock and one investor.
Liquidation preference lays out in what order and how much of the return investors will receive upon the sale of the company. This can have a significant impact on the founder’s return, so it’s worth considering expected exit values. As the terms accepted in a Series A round will likely carry over to future rounds, be very mindful in what you agree to.
Protective provisions, or “veto rights,” for investors over certain corporate actions are normal, but some can be to your detriment. For example, one you should be wary of in particular is a veto right on future financing – this can be tough to spot and may be included in a phrase like “no amendments to the certificate of incorporation without our approval.” The wording here can be tricky, so it’s in your best interest to review these closely with your lawyer.
Founder vesting is when founders agree that their founders stock will vest over an agreed upon time period, usually four years. Three things you’ll want to very pay close attention to with this are:
- The date on which vesting commences
- Whether or not vesting accelerates upon termination without cause
- Whether or not vesting accelerates upon a change of control OR upon termination of employment without cause within some period of time after a change of control
Anti-dilution protections guard investors against the future sales of preferred stock at a lower valuation. These protections are very common in preferred stock, though they can vary in the extent to which they protect investors. “Broad-based weighted average” anti-dilution protection is fairly mild, and essentially states that some amount of anti-dilution shares will be issued in the event that the company issues additional equity securities. “Full ratchet” anti-dilution protection can cause issues and means that should the company issue shares at a price lower than that of the Series A, then the Series A price is dropped to the price of the new issuance. Brad Feld, venture capitalist and entrepreneur, has a useful blog post that further breaks down how different anti-dilution protections can affect your startup.
It’s easy to get bogged by down by the little things when looking at a term sheet. This should not be taken as advice on the terms you should accept; rather, it should give you an idea of what to look for and what you should pay close attention to when negotiating terms. And remember, the terms you agree on in your Series A can follow you through later rounds, so you (and your lawyer) want to get it right the first time.