By Fernando Berrocal
The first official agreement between the founders of the startup and potential investors is known as a term sheet. Before the terms of an agreement are formalized into a legally binding contract, term sheets are used to negotiate final provisions–essentially laying out the investment's conditions. The organization and all parties involved benefit when both founder and investor objectives are aligned under a term sheet.
Depending on the investor's requirements and objectives, every term sheet is different. They all, however, should cover the following points.
Term Sheet Fundamentals
It can be challenging to accurately appraise the value of early-stage startups. There are a few proven techniques to make the process of determining their worth more simple. Before engaging in negotiations, it is crucial to have a complete understanding of the concepts you are discussing. You should list both pre and post-money valuations on a term sheet. The startup's value before funding is known as "pre-money"; “post-money" is the (resulting) total amount of all the investments.
- Option Pools
This is stock set aside for current (and future) team members. To start or grow an option pool, a term sheet is needed. You should decide how the stock will be split as more shares become available. Investors may benefit from pre-money option pools, since they render founders responsible for all future dilution. A post-money option pool that includes investors in future payouts tend to favor founders’ interests; the majority of option pools, however, are pre-money.
- Rights of Participation
Participation rights give investors two advantages: a guaranteed return on their investment (in the case of a loss) and a share of any money that is left. Having investors and founders on the same line is a good idea; however, there are situations where they might take opposing sides. Founders would rather not have these rights, but investors favor them greatly–they increase the return on investment. Even if participation rights are not included in typical term sheets, investors may insist on them. As a founder, you can feel confident in disagreeing with this stipulation. If an investor is insistent, you might want to limit their involvement.
The sum of cash an investor may get will be constrained as a result. Participation limitations are frequently placed at an amount that is more than your initial contribution. Your participation barrier might be set at two to three times your initial investment. This implies that following the first investment, holders of preferred shares must convert to common stock.
- Preference for Liquidation
Investors who have obtained preferred shares may use liquidation preference as a safety net. In the event of a company’s failure, preferred stockholders can recover some of their investment through this agreement. As a result, preferred investors receive their initial investment returned before common stockholders.
The fundamental mode of distributing profits to shareholders is through dividends. Dividends can be paid as stock or cash. Dividends are one of the factors that make stock "preferred," and they can also be a benefit to preferred owners. Dividends normally range from 5 to 15 percent, and build up over time. There are three types of dividends:
- Antidilution rights: If there is a down round, preferred stockholders are safeguarded. This occurs when the worth of a business declines after one series is over. The issuing of extra shares or a decrease in the price of preferred stock are both permitted under anti-dilution rights.
- Cumulative: These distributions are in the preferred investor's best interests. They are determined yearly using the original issue price. The sum is carried over into the following year until it is paid (since the business is unable to pay it).
- Non-cumulative: The board of directors must declare that it has the power to distribute dividends within a fiscal year. If not, then no one may make a dividend claim for that fiscal year. Dividends on the common stock must be paid before preferred stock dividends are available. If dividends on common stocks are paid, preferred stock dividends won't be accessible.
Many founders are surprised at the fact that their board will be a crucial growth component. Consequently, a section concerning the board of directors is frequently included in startup term sheets. Growth is essential, even if you are the sole founder and operator of your business. Equal numbers of members on a board of directors is supportive of founders and investors.
- Percentage of Ownership for Shareholders
Major decisions are frequently made by the board. However, certain choices may also be made by the shareholders. There should be a section on share class ownership percentages in your term sheet. This will make it clear how much of the business each person (and/or group) owns.
- Rights of Investors
Investors' rights are frequently included in term sheets. Consult with an attorney to ensure familiarity with all rights (since they might vary). Investor rights often refer to particular activities that investors are entitled to–or should expect to be able to take.
Common Term Sheet Mistakes
- Non-essential Fees: Some fees on a term sheet - including the board and monitoring costs - should be challenged. Both charge you for attending board meetings or keeping an eye on their assets. These costs are unjustified, and they can present issues for potential investors.
- Financing based on milestones: Everyone believes that funding based on milestones is a wise choice. If the firm achieves specific objectives, a second tranche will be issued. In some situations, such as when a firm doesn't reach predetermined milestones, investors have the authority to modify a deal's terms. Founders could occasionally only be qualified for a fraction of the investment. You may object to something that appears on a term sheet.
- Rights of redemption: Investors have the option to use their redemption rights to ask for their money returned. It makes no difference if your firm is successful. Whether the firm succeeds or fails, investors will get their money back. Redemption rights may cause issues if a business experiences financial difficulties and an investor unexpectedly asks for their money back.
- Multiple board seats per investor/per round: There should be one seat allotted for each round. Do not let several round seats be taken by avaricious investors. This can lower your ownership stake in the business–and perhaps restrict subsequent rounds.
Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.
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