Understanding the Term Sheet: Key Terms Every Founder Should Know
Securing funding is a pivotal moment for any startup. A term sheet is the first step in formalizing the relationship between the entrepreneur and the investor. This document outlines the terms and conditions of the investment, and understanding its components is crucial for founders. Below, we break down key terms every founder should know when navigating a term sheet.
1. Valuation
Pre-Money Valuation: This is the value of your company before the new investment is added. It reflects what investors think your company is worth before they put in their money.
Post-Money Valuation: This is the value of your company after the investment has been added. It’s calculated by adding the pre-money valuation to the amount of new equity raised.
Example: If your company’s pre-money valuation is $4 million and an investor puts in $1 million, the post-money valuation would be $5 million.
2. Investment Amount
This is the amount of money the investor is committing to invest in your company. It will impact the percentage of equity they receive based on the agreed valuation.
Example: With a $1 million investment in a company valued at $4 million pre-money, the investor would receive 20% of the company ($1 million / $5 million post-money valuation).
3. Equity and Ownership
Common Stock: Shares that are usually held by founders and employees. These stocks often come with voting rights but are subordinate to preferred stock in case of liquidation.
Preferred Stock: These shares come with certain privileges over common stock, such as dividend preferences and priority in the event of liquidation.
Example: If an investor purchases preferred stock, they may have the right to receive their investment back before any common stockholders in the event of a sale or liquidation of the company.
4. Liquidation Preference
This term defines the order in which investors are paid back in the event of a liquidation event, such as the sale of the company. It typically ensures that investors get their money back before common stockholders receive any proceeds.
Example: A 1x liquidation preference means the investor gets their initial investment back before anyone else is paid. If they invested $1 million, they get $1 million off the top of any liquidation proceeds.
5. Participation Rights
Participation rights allow investors to receive their liquidation preference and then participate in the remaining proceeds alongside common stockholders.
Non-Participating Preferred: Investors receive their liquidation preference but do not participate further in the remaining proceeds.
Participating Preferred: Investors receive their liquidation preference and then also share in the remaining proceeds as if they converted their preferred stock to common stock.
Example: With a 1x participating preferred, an investor gets their initial $1 million back and also shares in the remaining distribution.
6. Anti-Dilution Provisions
These provisions protect investors from dilution in the event of future equity rounds at a lower valuation than the current round.
Full Ratchet: Adjusts the conversion price of the preferred stock to the new lower price.
Weighted Average: Adjusts the conversion price based on a weighted average of the new and old prices.
Example: If an investor’s stock was priced at $10 per share, but the company issues new shares at $5, a full ratchet would adjust the investor’s price to $5 per share.
7. Voting Rights
These rights determine the degree of control investors have over company decisions. Preferred stock often comes with enhanced voting rights compared to common stock.
Example: Investors might require approval for major decisions like selling the company or issuing new shares, giving them significant influence over key business actions.
8. Board Composition
Investors often want representation on the company's board of directors to influence strategic decisions.
Example: A term sheet might specify that the board will consist of two founders, one investor, and one independent member agreed upon by both parties.
9. Dividends
Preferred stock often comes with dividend rights, which can be cumulative or non-cumulative. Cumulative dividends accrue over time and must be paid out before any dividends can be paid to common stockholders.
Example: If a preferred stock has a 6% cumulative dividend, the company must pay 6% annually on the investment amount before any dividends go to common stockholders.
10. Exit Strategy
An exit strategy outlines the expected method and timeline for the investors to get a return on their investment, such as an IPO or acquisition.
Example: A term sheet might specify that the company must pursue an IPO within five years, providing a clear timeframe for the investor's return.
Conclusion
Understanding these key terms in a term sheet is crucial for founders to negotiate effectively and secure favorable terms. By knowing what each term means and how it impacts your startup, you can make informed decisions that align with your long-term vision.
Tactical Steps for Founders:
- Educate Yourself: Take the time to thoroughly understand each term in the term sheet.
- Seek Legal Counsel: Work with a lawyer experienced in startup funding to review and negotiate the term sheet.
- Negotiate Fairly: Aim for a balance that protects your interests while offering a fair deal to investors.
- Plan for the Future: Ensure the terms align with your long-term goals and exit strategy.
By mastering the nuances of term sheets, founders can better navigate the complex landscape of venture capital and secure the funding needed to grow their businesses.