Understanding term sheets
Every entrepreneur who raises money seeks one thing in common: a term sheet. Term sheets come in all shapes and sizes and can be used for equity or debt investments. Some lucky companies get more than one term sheet, which enables them to have leverage in a negotiation. With these different permutations, there are many things
to consider. In this chapter I will present all the major issues around term sheets and provide some pragmatic guidance.
What is a term sheet?
A term sheet is a nonbinding document that summarizes the major deal points of a contemplated transaction. In other words, it’s an informal agreement between two parties who are thinking about doing a deal, in this case a financing between an investor and a company. Getting a term sheet, while exciting, is only the first step to getting money in your bank account, but it is a very important step because it spells out each party’s intentions. In most cases, once a term sheet is issued, an actual binding contract is consummated. Only when one party acts badly do deals not close.
What really matters?
Valuation. Liquidation preferences. Protective provisions. Antidilution. Board seats. Option pools. Registration rights. Attorney fees. Conditions to closing . . .
Take a deep breath. It’s okay. We’ll get to all of this, but there are only three things that matter when negotiating a term sheet:
- Understanding the agreement you accepted;
- Making sure that incentives between you and your investors are aligned; and
- Making sure the relationship with your investor (and most likely future board member) was enhanced through the process of negotiating the term sheet, not harmed.
It’s amazing to me how many times I meet entrepreneurs who don’t understand the ramifications of the term sheet they just signed. Sure, money is coming in the door, but has the value of the company shifted to the investors? No matter how much entrepreneurs study this, they’ll never be as experienced as a seasoned venture capitalist (VC). For this reason, it’s imperative that good legal counsel be consulted.
I would also recommend, regardless of who the lawyers are, that every entrepreneur should have an experienced mentor who can provide feedback.
For every term in the term sheet, consider whether that term aligns or misaligns incentives between the parties. For instance, if an investor asked for the ability to veto a sale of the company for a purchase price under $30 million, what misalignments could exist? Perhaps at a $25 million sale you’d be wealthy beyond your imagination while the VC would hold out and block the deal. When you find a provision in a term sheet that bothers you, consider whether or not alignment is an issue. If you push back and argue alignment of incentives, you have a much stronger position than “it’s not market” or “I don’t like it.” If your VC isn’t interested in incentive alignment, that should tell you something important about the person who you are dealing with.
Lastly, consider the long-term dynamics around relationships. If I were to offer you a term sheet and you were to stick your aggressive and overbearing lawyer on me, that is going to negatively affect our relationship. Every person whom you introduce me to (regardless if they are your cofounder or a service provider) is a reflection on you. Given that I’m going to be working closely with you for the next several years (it’s not uncommon that I’ll work a decade with an entrepreneur), it’s wise for us to both start out on the right foot. Strongly consider whom you choose to represent you when negotiating with an investor.
Ultimately, keep it simple. Term sheets pale in significance to building a company and the working relationship you will want with your investors. This goes both ways, too. If your future investors aren’t behaving well, consider other options.
The terms that matter
While there are many terms to understand, there are only two types of terms that matter. They are 1) economics and 2) control.
When considering any provision in a term sheet, ask yourself the question, “Does this provision affect either who controls the company or how the economics (returns) are divided up by the parties on a sale of the business?” If the answer to either of these is “yes,” then the provision matters and you should focus on it. If the answer is “no,” then you are dealing with a much less important issue.
The most important economic term is valuation. This is also usually the toughest term to negotiate. Some people don’t want to negotiate a valuation and choose to use instruments other than equity, such as convertible debt. We’ll talk about those later. For now, let’s assume that you are going the most common route, which is selling preferred stock in your company to an investor.
Valuation is a simple concept to understand. There are only three things to keep in mind:
- Pre-money valuation: This is the value that is agreed upon as what the company is worth before the investor puts money into your bank account;
- The investment amount: This is the amount of money the investor is offering you; and
- Post-money valuation: This is the pre-money valuation plus the investment amount.
For example, if I offered you $4 million at a $6 million pre-money valuation, then the post- money valuation would be $10 million. Since I put in $4 million and the post-money valuation is $10 million, I would own 40 percent of the company after the financing.
Note that if I changed my offer to an $8 million pre-money valuation, then the post-money valuation would be $12 million and I would own 33 percent of the company post financing. Valuation is the factor that most directly impacts the entrepreneur’s return because it defines who owns what piece of the pie.
Be careful when you are discussing valuation with an investor. Often you will hear an investor say, “I’ll give you $4 million at a $10 million valuation.” It’s likely that she is thinking post- money, not pre-money as the entrepreneur often thinks. Make sure that you are speaking the same language.
The next economic term to consider is liquidation preferences. This term comes into play when a company is liquidated. In English, this means the company is sold (whether the outcome is good or bad), shut down, or sells off all its assets. Liquidation preferences allow for the investors (who normally buy preferred stock) to get their money back before money goes to the common stockholders, which normally includes founders and employees. There are several types of preferences.
First up is the simple “1x preference” which stands for “one times back your money.” In our example where I put $4 million into a company and own 40 percent of the company, I have a choice of getting from the proceeds either the percentage I own or the first $4 million of proceeds in a liquidation event. If the company sells for $4 million or less, I would take all the proceeds. If the company sells for $6 million, I would take $4 million, leaving $2 million left over for the common holders. If the company sells for $50 million, I would take 40 percent of the proceeds, or $20 million, leaving $30 million for the common holders.
There are other situations (usually when a company is in dire straits or having a very difficult time raising money) where one will see a 2x or higher multiples. In a 2x preference situation, I would have the choice to take the first $8 million off the table from a liquidity event. Thankfully for entrepreneurs, it’s typical in the VC industry to see a 1x preference.
After looking for what type of liquidation preference is being offered by an investor, check to see if there is also participation as well. If the preferred stock is participating, then after the liquidation preference is received, the investors will continue to receive proceeds based on their ownership. Let’s go back to our example of an investment amount of $4 million and pre-money valuation of $6 million. Assuming I’m the only investor, I own 40 percent of the capital stock of the company. If I have a 1x preference and my stock is also participating, then in any liquidity event, I’ll take the first $4 million of proceeds, then 40 percent of whatever is left.
If this sounds like a lot of money flying out the door to your investors, realize that the participation right has even greater impact as you raise more money. Try to negotiate your way out of giving a participation right, even if it means trading for a lower valuation. If you can’t negotiate the participation away, try to put a cap on the participation so that investors stop participating once they hit 2x or 3x their investment amount. This is called capped participation.
Next on our list to address is the role of the option pool. The option pool is the amount of stock set aside to grant to current and future employees of the company. While you may think that this is something that founders and CEOs should decide, investors will want to make sure that the option pool is large enough to hire all your new employees with the proceeds from the financing. In most cases, this isn’t a contentious argument, but beware that whatever option pool is agreed upon comes out of your ownership, not the investors’.
For instance, if you and I agree to a 10 percent option pool being available post my investment, the option pool is created before I put my money in the company. This 10 percent option pool comes out of your ownership (and any other founders, employees, or period investors as well), so you are immediately diluted 10 percent just from the option pool itself. Be very careful if you are judging two term sheets that you have. One may have a higher pre-money valuation, but if the option pool is twice the size of the other term sheet, you could end up owning less of your company despite the higher valuation.
Antidilution protection is a provision in almost every VC deal. Antidilution protection gives a benefit to current investors if, in the future, stock of the company is sold at a lower price than previous rounds. In other words, if you sell me stock at $2.00 a share and then the next round is priced at $1.00, I will have my effective price adjusted downward. In the most extreme cases, called full ratchet protection, my price would be lowered to $1.00. This results in my doubling my ownership at the expense of the founders and employees. More typically, VCs ask for weighted average protection, which looks at how many shares were sold, not just the price, in order to determine how significant the financing actually was. In this case the effect of the dilution is muted but can still be large. There are complicated math equations that determine all of this that are beyond the scope of this chapter. Ultimately, try to never agree to full ratchet anti- dilution and make sure that your lawyer is paying attention to this term.
Dividends look a lot like an interest payment on your credit card debt or mortgage. You agree to pay a certain percentage automatically while your debt is outstanding. In a VC deal, an 8 percent dividend would mean you would pay out in cash or stock 8 percent of the investment amount every year (in our case $320,000).
While dividends are common in hedge fund and private equity deals, they are very rare in the VC world. Normally one would expect to see a dividend provision that was contingent on the board approving the actual payment. No reasonable investor, in my opinion, would want to take money out of the company this way nor deserve an 8 percent free stock grant every year.
Now that we’ve addressed some of the economic terms, let’s look to the other important type of terms: ones that affect the control of the company. The two most important ones are board of directors and protective provisions.
Pay attention to who sits on your board of directors and who controls the ability to elect members. Among the powers and legal responsibilities that a board has is the power to hire and fire the CEO. When negotiating a term sheet, expect that the lead investor in your round will request a board seat. (This may not be the case if you are raising a smaller seed-type round.) Assuming the CEO/founder takes a seat, what does that say about the remaining seats? Here are some suggestions:
- Keep the board A well-functioning board should be strategic and nimble. The more peo- ple in the room, the less functional the board will be; and
- In the early stages of your company, expect to have a balanced board. This means the investor(s) will get one seat, the CEO will have a seat, and then an outside board member (a person who is a noninvestor and nonemployee) will make up the other seat. In the case of a five-person board, there will usually be two company board members (CEO plus one), two investors, and an outsider.
The concept of a balanced board scares some entrepreneurs, but if you are working with a reputable investor, it’s rarely an issue. The key is creating a board that is your true inner sanctum. This is the group that you trust with your biggest issues and look to for guidance.
While there are other terms that affect control, the second most important one is which protective provisions exist. Normally, the protective provisions allow the preferred stockholders to have a veto right over certain actions the company could take, including issuing new stock, changing the terms of the existing stock, selling the company, and taking on debt. You can try to fight these, but over the past decade these have become standard terms. Rather than fight each term, you should try to keep all of your preferred stockholders voting together as a single class. If you give every new investor in each round a separate set of protective provisions, it’s much harder to get things done.
Other terms - the ones that matter less
There are many other terms that we could discuss, but this chapter would soon become a book (more on that later). We’ve discussed the most important ones but be prepared to deal with things like attorney fees where you negotiate how much you’ll pay to your investor’s counsel to get the deal done. You’ll see arcane terms like registration rights, which will talk about a whole bunch of stuff concerned with going public one day. Don’t worry, none of this is complicated, nor does it all matter that much. If you find the other side arguing strongly about these terms, you should be concerned about their focus and priorities.
In generalizing a lot of information, be wary of certain caveats. Not all investors are the same, and as you deal with later-stage investors, terms tend to diverge more than at the early stages.
Furthermore, this is a discussion about equity term sheets only. If you find yourself negotiating a convertible debt deal, things are quite different. You’ll likely be negotiating fewer terms, including the amount of the financing, the interest rate (as low as possible is the norm), terms regarding how the debt converts into equity at the next financing, and what happens if the company is acquired while the convertible debt is outstanding. In these cases, it’s possible for debt to convert at a moderate (10 to 30 percent) discount to the next round and even potentially have a valuation cap, which puts an upper limit to the valuation at which the debt can convert.
Where to more help
Remember that regardless of how well you think you understand these terms, most VCs will have a lot more experience than you. They’ve likely negotiated tens or hundreds of deals before, so make sure that you have competent legal counsel to help you. Keep in mind that this chapter is a very high-level summary of some of the important issues. If you are looking to dive deeper into all things about term sheets (for equity, debt, and acquisitions), raising money, negotiating, and learning about what really motivates VCs, I encourage you to get a copy of the book Venture Deals, How to Be Smarter Than Your Lawyer and VC, coauthored by myself and my Foundry Group partner Brad Feld.
Jason Mendelson, Managing Director, Foundry Group