Term sheets, the non-binding documents containing terms and conditions for potential investment, are presented to entrepreneurs after they have made a successful pitch to an investor. It broadly covers 3 areas: Funding, Corporate Governance and Liquidation, all of which are equally important. It forms the basis for negotiations between the parties on final terms and conditions, after which the final contract is drawn up and signed. Term sheets are so important that they are often equated to prenuptial agreements. So, startups must understand it thoroughly to be able to negotiate effectively and get a good deal. Here are the key things startups must know about term sheets:
Valuation: The first step in any negotiation with investors is agreeing on the valuation of the startup. Valuation is nothing but the net worth of the startup or price per share. Both pre- and post-money valuations are both included. Valuation has implications on the level of control the founders will have in the startup, the involvement of investors in settlements (in case of dilution) as well as the ability to raise funds in the future.
Kind of shares offered: There are different categories of shares that can be offered to investors in exchange for their investment. The nature of shares offered has implications on the level of power and control they will wield in the startup and their rights in general and in case of liquidation. Investors always opt for preferred shares since it offers them rights that are not available to common shareholders.
Liquidation preference: Liquidation preference is the kind of reimbursement investors will get in case the startup shuts down and the assets are being liquidated for settlement. Though it is advisable for startups to agree for 1X liquidation preference so that investors will at the minimum get back what they have invested, but it is possible for investors to demand multiple preference as well.
Participation Rights: Through participation rights, investors get higher returns upon liquidation and often insist on including it in term sheets. But it is not standard practice to include it and founders must ensure it is not included. In case the investors are too insistent, then a cap should be considered to protect the interest of the founders.
Option Pools: The set of stocks reserved for current and future employees to retain them is an option pool. An important consideration here is whether option pools are included in pre- or post-money valuations. If included in pre-money, the entire burden will have to borne by the founders in case of dilution.
Dividend rights: Dividends are a portion of profits that are distributed among equity shareholders. But startups, in the initial period, tend to reinvest all profits into the business. The kind of dividend offered (cumulative, non-cumulative, anti-dilution rights) has future implications for the startup and so, careful consideration is a must. Non-cumulative dividends serve the interest of startups best.
Board Composition affects the level of control founders and investors wield in the startup. It is, therefore, important to consider the size and composition of the board carefully. Offering multiple positions on the board for a single investor must be avoided.
Founder Provisions: Founders and the management of the startup are essentially its representatives and having them onboard for a longer period gives investors a sense of trust and confidence in the startup. Term sheets will include founder vesting schedules to ensure they do not leave in the short-term.
Investor Rights: Several clauses and rights are included in this broad head and startups must consult with their lawyer regarding this.
Voting Rights: Despite being preferred shareholders, investors get voting rights like common shareholders. The circumstances and areas of decision-making they get voting rights in are detailed in the term sheet.
Consent Rights: Major decisions that impact the startup in a big way will need the consent of the investors and this forms the consent rights in term sheets.
Entrepreneurs must be well-prepared before entering term sheet negotiations with investors. They must know the implications of various terms and clauses on their overall returns, control and ownership of the startup, not just in the present but in the future too. They must keep the best interest of their startup in mind.
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