What is a Term Sheet?

6 mins read

So you’ve got big dreams of Mark Zuckerberg fame and fortune with your startup.

Okay, cool.

But you’re going to need some money to pull it off. It takes money to make money, and if you don’t come from a wealthy family in Lichtenstein, you might end up with a term sheet as the first step in your negotiation with a professional capital investor.

A term sheet is a fairly short, concise, but powerful legal document that outlines the very high level details of a proposed investment or acquisition. Don’t let the abbreviation of a term sheet lull you into any sense of the document itself being as important as its length. The entire financial future of the company is impacted by the little details on the term sheet.

If you’re out shopping for capital investment, here are a few common terms you’re going to see when you get lucky (or unlucky) enough to have a term sheet floated your way.

Pre-money Valuation

This is the value of your company as it sits today without any additional sales, profit, or investment capital injection. It’s an important number because a pre-money valuation establishes the baseline ratio against the proposed investment. For example, if your pre-money valuation is $1 million, and an investor puts $1 million into your deal, your post-money valuation is going to be $2 million. Well, duh that’s sort of basic math, right? So this means the equity of the company in question for the $1 million is going to be 50%. But if the pre-money valuation is $1.2 million with $1 million in, the equity consideration is approximately 45%. One million invested against $2.2 post money valuation equals 45% (or thereabout). Don’t undervalue your current business asset.

Liquidation Preference

There is a distinction between types of preferred preferences, and it makes a difference with future financing needs depending on your balance sheet ratios. Participating vs. non-participating preferred means investors may or may not get a double dip in the event of a sale.

For early stage investments like seed stage, non-participating preferred is most common at a 1x ratio. Whenever a major discrepancy exists between the founders and investors regarding the pre-money valuation, many times an investor will concede the valuation but hedge their bet by shifting to participating preferred. Investors like to hedge their bets – and this aligns with my own core philosophy, “Your price, my terms.”

Dividends

It’s rare to find dividends on an early stage term sheet. However, be aware that it can exist and will dramatically impact your cash flow should you be required to meet the payment arrangement. Dividends are similar to interest payments on the preferred shares, and are used to boost returns to the investors.

A common form of security is a cumulative convertible preferred issue, which means the dividend is allocated but not paid. It accumulates (and usually compounds) so the investors take a deeper slice on conversion in the event of a sale or other triggering event.

Anti-Dilution

While it’s expected that everyone will dilute with each subsequent round of financing, the goal of anti-dilution language on a term sheet is to ensure the dilution occurs proportionately. In the event of a future round of financing at a lower valuation, anti-dilution language gives previous investors more shares to help balance against the new, reduced share price. Weighted averages are the most common form, and it simply ensures the previous investors don’t get edged out incrementally because some new round of funding puts the valuation at a lower ratio.

Option Pool

This has become one of the hotly debated topics in venture investing because the option pool is the “set aside” for future employees. Every time a round of investment takes place, investors often want to see equity allocation to the stock option pool in the 10-20% range. A big consideration is whether or not to model the option pool pre-money or post-money valuation. There’s always a big difference to the founders.

Other common terms you’ll find on a term sheet will be things like pro-rata rights, information rights, registration rights, and disclosures. It’s always best for any founding team to bounce any term sheet off their legal representation, and specifically attorneys who are familiar with startups and equity investment vs. some general practitioner personal injury friend of a friend. I’ve seen more than one deal go into the tank because of an ill-equipped attorney playing outside their field of expertise.

Yes, every attorney should want to get the best deal possible for their client. But much like the draconian terms of the average home loan, the game is heavily weighted towards the investor.

Quite simply, the old adage still holds true, “He who has the gold makes the rules.”

Just be sure to understand what those rules are, and why they exist. Learn the playing field and work to win for everyone.

 

Michael Hiles

CEO 10XTS, INTJ, chaotic good, PDP/11 in '79 (THAT kid), info architect, Milton Friedman, data science, semantics, epistemology, coffee snob, OG hip hop

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