Running a startup takes hours and hours of hyper focused time. It’s unlikely that any of your time is devoted to learning the arcane legalese that venture capital funds use in their term sheets.
Terms like “anti-dilution provisions,” “liquidation preference,” and “option pool” likely make little to no sense to you if this is your first rodeo.
Read on to learn how to interpret your term sheet and what all those terms really mean.
Overview: What is a term sheet?
A term sheet is a nonbinding offer of equity investment from a venture capital (VC) fund. The sheet lays out the terms of what will become the eventual agreement with the fund.
If you’ve gotten a term sheet agreement, it is a great benchmark in your fundraising process. It means the fund has likely approved an investment and wants to start negotiating terms.
That said, a term sheet is just the starting point. Any private equity investment will hinge on the due diligence of the investor. Read your term sheet closely and get a lawyer to read it as well. If the fund has approved an investment, that means they want to be involved in your company and you may have leverage to negotiate the deal.
The terms that the term sheet specifies
It would take anto go over every single term you could see, so we’ll just go over the most common and most important.
Pre- and post-money valuation
The pre-money valuation is the implied value of your company before the investment. When talking to your VC, if they say, “We believe your company is worth $10 million,” verify that they mean pre-money. If they believe your company is worth $10 million after they make a $3 million investment and you believe it is worth $10 million before, there is a big gulf in your two valuations.
Post-money valuation is the implied valuation of the company after the investment. If the fund invests $1 million for a 10% stake, that implies a post-money value of $10 million ($1 million / 10%).
Type of security and liquidation preference
Most VC investments are purchases of convertible preferred shares. Preferred stock is stock that has a liquidity preference (meaning they get paid out first in the event of a sale or liquidation) over common stock, but can be converted to common stock to participate in the upside.
Write down the conversion price — this is the price at which the preferred shares will be converted to common shares — and you will need to know it if there is an anti-dilution provision.
While preferred stock has a liquidity preference over common stock, VCs may also add a liquidation preference dictating that they must be paid a certain multiple of their original investment before other equity investors are paid.
Also be on the lookout for participation. It isn’t as popular as it once was but it can dilute founder shares. Participation allows investors to earn their liquidation preference and participate in the remaining pool of profits if a sale happens.
Warrants and Dividends
These are sweeteners for the investor. A “warrant” is a type of stock option. It gives the holder the right to buy stock at a specific strike price at some point in the future. “Dividends” are cash paid out of the company’s pocket into the shareholders’.
Dividends are rarely agreed to in VC deals — startups need all the cash they can get and a vampire capita…, er, venture capitalist, sucking the life blood out of the business won’t work out.
Because you run an exciting startup, it is likely easier to motivate and attract good employees with stock options than with straight cash. Everyone loves a lottery ticket. The term sheet will leave aside a percent of the total equity amount to be used as future stock option compensation.
The option pool shares will likely come from the founder’s portion of ownership. The bigger the option pool, the easier time you will have attracting top talent; but it also means you end up with less ownership at the end of the day.
If you have a round where the pre-money valuation is less than the post-money valuation of a prior round, the anti-dilution provision ratchets the fund’s conversion price back to the new valuation.
In English, that means if the conversion price of the convertible preferred shares we talked about above goes down in a future round, the VC is protected from their investment being diluted because their conversion price changes to be the same amount.
When a round has a lower valuation than the previous round, it is referred to as a “down round.” Flat rounds are when there is no change, and up rounds are what everyone wants: an increase in value.
Pay to Play
Pay to play provisions help you. The provision ensures that all investors will have to invest in future rounds — even if they are a “down round” — or risk losing various rights.
I worked on a pay-to-play round doing projected returns for our fund. Our projected returns of investing in the round were in the thousands of percent because the opportunity cost of not investing was so steep. It was the strangest table I’ve ever seen in a PowerPoint.
VCs don’t trust management. They will try to get their own representatives on your board. This can be very helpful, but keep in mind that CEOs like Steve Jobs (Apple), Travis Kalanick (Uber), and Rick Alden (Skull Candy) were forced out of their positions by their boards of directors.
Right of first refusal
If any of the management team or even investors wants to sell their shares, this gives the VC the right to buy them before anyone else.
What is the benefit of having a term sheet?
Receiving a term sheet will have you swimming in arcane language and even having to, gasp, talk to lawyers. So what are the benefits to getting a term sheet?
Gives you the opportunity to negotiate
The term sheet is the first step to negotiating the final investment, and the lawyers will use the term sheet to build final docs. Make sure you understand the term sheet well and know which terms you are fine with and which are nonnegotiable. Use your leverage to make the investment as friendly to you and your business as possible.
It is a clear signal from the VC
The term sheet is a clear sign from investors that they are interested in your company. They’ve listened to your pitch, read your plan, and studied your financial projections and the answer is, “Yes.”
The next step is for you to ask, “At what price?”
It makes your company seem more respectable
You typically cannot shop around a term sheet or even disclose that you have received one. But word gets around, and you will be able to gain experience with the negotiation to use in the next round.
Better to work on a term sheet than a spreadsheet
You should now have a general idea of what most of these frequently used terms mean. It will be up to you and your lawyer to determine which to negotiate away or to keep so that you can get back to hours and hours of hyper-focused studying of business metrics.
View more information: https://www.fool.com/the-blueprint/term-sheet/