What’s in a term sheet, and what do entrepreneurs need to know before they sign one?
The term sheet is one of the most critical documents an entrepreneur can ever design or sign. By this stage you’ve put in a ton of sweat equity, honed a product, crafted a successful pitch deck and aced investor meetings. The rest of your life, the dreams you have for your startup baby, and how much you are going to enjoy growing this company is going to rely on these terms and what comes next.
How you presented your company via your pitch deck is really what got you so far with that potential investor that you are about to onboard. I recently covered the pitch deck template that was created by Silicon Valley legend Peter Thiel (see it here). I also provide a commentary on a pitch deck from an Uber competitor that has raised over $400M (see it here).
The Importance of Acing the Term Sheet for Startups
Unfortunately, they don’t teach term sheets in school. With so many other tasks, many entrepreneurs can get to this point with barely any understanding of what a term sheet looks like, what is and isn’t standard or a good deal, and how to negotiate.
It’s wise to get ahead of the game. Have your terms in mind from the founding of the venture, and be working strategically to optimize the outcome of these negotiations even before you pitch or catch the scent of a check.
The Startup Garage reminds us of the main goals to guide entrepreneurs when it comes to term sheets:
- You want to raise as much capital as possible, while giving up as little of the company as possible.
- To ensure that you have not given up too much of the upside potential or assumed too much risk on the downside potential.
Important Clauses to Cover in Your Term Sheet
There are a variety of term sheet formats out there today. That includes traditional equity fundraising term sheets, convertible debt, KISS and SAFE docs. Make sure to master whatever type of instrument you’ll be using.
Here are common terms, clauses and factors you’ll need to know and decide at some point for all types of fundraising, and which you’ll find in the National Venture Capital Association (NVCA) term sheet template.
Who, What and How Much
The main part of this document lays out the different angel or venture capital firms participating in the round, how much they are investing, and what they are paying per share. This is all about the valuation and ownership percentages.
There have been plenty of high profile horror stories of founders who have been ousted from their own companies. There are likely many more hiding under a desk somewhere, experiencing the soul crushing realization they have no control over their own ventures anymore.
Picking the right investors is important. Yet, it is always smart to have the paperwork in your favor as much as possible, just in case they aren’t the people you thought they were. Don’t get stuck on that first or next check. Think big picture. You can bet they are.
This is especially true with convertible debt and what valuation figures will be based on later.
This sets aside the pool of shares which will be available for future hires or investors. This might not appear to be a big deal now. Yet, it can impact valuation and will certainly factor into the dilution of shares. As the founders you don’t want to be soaking up all the dilution, without your investors experiencing the same impact.
Liquidation & Participation
This clause dictates how much investors and preferred stockholders are owed before everyone else when the company is sold. A 1x preference means they get 100% of their money back before anyone else gets a penny. Any more than that means they’ll get more than their investment returned.
Participation rights can also give preferred stockholders a percentage of any proceeds in an exit on top of the return of their investment. If you sell for $10M, and they have a 1x liquidation preference and 30% participation rights, then if they invested $5M, they get that back, plus another $1.5M, leaving only $3.5M for everyone else to split.
Dividends may or may not accrue. If they accrue from the beginning that money needs to be added to the investors’ share of the proceeds in a sale. Be careful here, and who has the rights to demand when a dividend payout is right.
One of the most notable protective provisions will be an anti-dilution clause. Make sure you understand the rights to dilute stock and the calculation used.
You will likely either have a set number of board seats and appointments or ownership percentages of voting share classes. The main factor here is whether the majority of the seats or shares are held by investor versus founder-friendly shareholders or members. This will dictate who really gets to make the decisions, and decides whether you keep your jobs or not.
While you don’t want to give too much away, be aware that holding too much super-voting power can also be a major concern for potential investors. Ideally you’ll hold enough to protect your values and vision, while encouraging the maximum amount of investment from the best participants.
It is important to note that term sheets are usually not binding. Ultimately they act as a summary of the terms that will be drafted by lawyers in order to close the financing round.
One investing nightmare that tends to recur is when founders receive a term sheet and think the deal is done. They start increasing expenses, thinking the money will be transferred. I’ve personally witnessed instances where a founder with a term sheet ended up not closing the deal, and the founder had to shut down because it was assumed that the money was already in place. Do not be one of these cases.