Simple Guide to Evaluating Term Sheets from Investors as a Startup Founder
The process of raising investment capital for your startup can be complicated. So, we have put together this guide to help you understand the key terms to watch out for when evaluating a term sheet from a potential investor.
After you send a pitch deck to a potential investor and they have expressed interest to invest, the next step is usually sending over a term sheet.
What is a term sheet? A term sheet is simply a document that outlines the terms under which the investor is willing to write your company a check.
The term sheet itself is generally not binding and is more like a proposal which will form the basis of the various legally binding documents that will spell out the investment terms in more detail. Those legally binding documents are called Definitive Agreements.
Between the presentation of the term sheet and the preparation of the investment documents, the startup and investor will negotiate the terms of the investment and conduct proper legal due diligence on the company. In our experience negotiating term sheets on behalf of both clients and investors, we have seen that startups often take term sheets as-is and get worse terms than they could have, or they focus on the wrong issues and lose out on the actual important terms which would affect their businesses significantly in future.
While there are standard term sheet templates, it is important to be aware that every term is negotiable depending on the peculiarities on how your startup is setup. So do not hesitate to ask for clarification on any terms you do not understand.
While acknowledging that each startup, investor, and investment transaction will be different and startups will need custom advice from experienced investment lawyers, here are some points to look out for when presented with a term sheet:
Deal Economics
These are the terms that have to do with the money involved in the investment transaction. The first term here will be the investment amount, and where it is a syndicate of investors, the amounts being invested by each one of them. Valuation is the next item, and it is always important to clarify if the quoted sum is the pre-money or post-money valuation. In the former, the amount refers to how much your company is worth excluding the funding that you are raising, while the latter refers to the company’s worth immediately after you receive the investment. For example, if your company is raising $500,000 at a pre-money valuation of $1,000,000; it means after the investment round is over, the company will be valued at $1,500,000. But if you are raising $500,000 at a post-money valuation of $1,000,000 then the company is worth $1,000,000 after the investment round is over.
To make it even clearer, an investor putting in $200,000 at the pre-money valuation of $1,000,000 in an investment round where the company is raising $500,000, will get about 16% of the company while if the investor was putting in the same $200,000 at a post-money valuation of $1,000,000, they would get 20% of the company. Clearly, the impact of the pre-money/post-money distinction can be very significant.
The liquidation preference is the next crucial clause. It stipulates who gets paid first and how much they get in the event of a liquidation, a bankruptcy, or a sale. The preference is usually in a multiple, such as 1x or 2x. If the liquidation preference is 2x, it means the investor will be entitled to get twice their investment before other shareholders share the remainder.
The participation rights clause usually follows closely, stating if and how much an investor will be entitled to share from the remaining funds, after exercising their liquidation preferences. It can be “non-participating”, where they don’t share at all, or “participating” where they receive a pro-rata share based on the number of shares they hold.
Investor Rights
Investors want to protect their investment, and several clauses in the term sheet will be designed to give them security in a variety of circumstances. An anti-dilution clause is very common, and with one in place, the startup will not be able to dilute investors by selling stock to others at a lower price than the initial investor paid.
They usually appear in one of these forms; weighted average anti-dilution and ratchet based anti-dilution, each of which will have unique impacts on the startup’s finances in the future. A ratchet based anti-dilution clause will mandate that an investor’s preferred shares convert retroactively to match any lower price offered in any sale of shares. This could result in a drastic dilution of the founders’ holding. A weighted average anti-dilution clause uses a formula to peg the reduction in conversion price to the number of new shares being sold, thus preventing drastic dilutions of the founders’ shares, especially when only a few shares are being sold.
Pre-emptive rights (also called pro-rata rights) are clauses that give investors the right to continue investing in the company’s subsequent fundraising rounds with sums that allow them to maintain their level of stock ownership. One of the things to consider when evaluating this term is that as the company grows, some investors might only want to invest if they can get a sizeable portion of equity, and if you’ve allocated too much pro-rata investment rights, it might be difficult to match a new investor’s requirements.
The Right of First Refusal and Co-sale clauses come into effect when shares in the company are to be sold by any shareholder. The former gives the investor the right to purchase any shares that are up for sale before such shares are offered to anyone else, and the second allows the investor to include their shares into any sale transaction, at the exact same terms. The Co-sale rights are usually present to protect minority investors who are then able to sell their shares under the same terms as say a major investor who is selling off their equity in the company.
Corporate Governance and Management
Corporate governance and management clauses serve to establish which parties have control of the company, in terms of day-to-day management as well as structural decisions. Some of the pivotal terms in this category are voting rights, board rights, and information rights. Voting rights clauses regulate how voting power will be divided among the shareholders (and among the various classes of shares), and they can also require that particular shareholders (usually the holders of preferred shares) approve some actions such as changes to the composition of the board, a sale of the company and the declaration of dividends.
Investors often ask for seats on the company’s board of directors, to allow them to directly oversee the management of the company. The clauses onboard rights would define the number of people on the board, the quorum for meetings, and possibly veto powers for specific members of the board, similar to the shareholder approval requirements above. Often, startups choose to give informal advisory seats instead of Board of Director seats to investors in the early stages of the startup.
Lastly, information rights require the company to share the reports and other documents detailing the company’s financial and business condition with the investors at specified intervals. The reports are often stated to be due on a quarterly basis, although there would typically be a provision that the investors can ask for updates at other times.
Exits and Liquidity
All investors put money into startups with the hope of making returns after an exit, whether that is in the form of an IPO, acquisition, or other types of exits. The redemption rights clause is one that startups must pay particular attention to. Depending on how it is constructed, it may allow investors to demand for their stock to be bought back by the company within a specified period. If such a demand is made at an inopportune time, it may create a liquidity crisis for the company and force the company to sell important assets or enter a hasty, less-beneficial acquisition, or financing deal.
Drag along rights are also crucial. They work by mandating minority shareholders to sell their shares along with a majority (of at least a specified percentage) when that majority has made the decision to sell. They serve to prevent situations where a minority shareholder will be able to block the sale of a company when the majority of shareholders have agreed to proceed. This is important because buying companies often want to purchase the entire company or at least a significant majority and may withdraw if they cannot meet that target..
Conclusion
The points discussed above represent some of the most crucial terms in any startup investment negotiation. They are often the difference between a “good-deal” or a “bad-deal”.
To achieve a balance of interests on both sides of the table, there are usually some trade-offs by both parties. When armed with the correct knowledge and with the guidance of experienced startup lawyers, founders can avoid the pitfalls of a poorly-negotiated term sheet, make the right trade-offs, secure the best possible terms, and consummate a transaction that will propel the startup to success.