When negotiating investments for your startup, you’re going to find yourself face to face with term sheets. Having an understanding of the key terms of a term sheet can make a great difference in the effectiveness of any deals that you make, since term sheets lay the foundation for any investment. Having the right terms in place can determine the overall relationship between your startup and venture capital (VC) investors and impact the final legal contract made between the two parties.
We’ve outlined some of the key things you need to know when approaching a term sheet in order to secure the best investments for your startup.
What is a term sheet?
A term sheet is a summary of the proposed key terms of an investment in your startup. The terms outline the conditions between your company and your investors and serve as a blueprint for the formal legal paperwork later drafted by lawyers. Typically, with a term sheet you agree to confidentiality and not to enter into negotiations with multiple investors at the same time.
If you’re creating a term sheet of your own, you may want to consider using a template. The National Venture Capital Association (NVCA) can be a great resource for finding a general term sheet template depending on your situation. If you’re specifically interested in a Series A term sheet template, Y Combinator offers a term sheet that covers everything in a shortened format that is more user-friendly.
The terminology of term sheets
Most investors know that creating a win-win situation within a term sheet is best for getting a good return on capital. But there are some cases in which certain terms can be included that result in a founder unwittingly giving up more control than they desired. To avoid running into such situations, it’s good to have a clear understanding of the different aspects of a term sheet and the specific terminology that may be used.
Economics & Control
In a term sheet, economics and control refer to the percentage of your company that new investors will own. These percentages can vary based on the company’s valuation and the amount of money that’s being invested. Having these percentages clearly established can help to clarify who owns what and how much each shareholder can expect to get if the company sells.
Some terms to know regarding economics and control:
- Pre-money valuation is the value your startup holds before receiving funding.
- Post-money valuation is the value that your startup holds after receiving venture capital investment.
- Liquidation preference defines the return an investor receives when you sell your company.
- Conversion rights give investors the ability to convert shares of preferred stock into shares of common stock. Typically, when conversion rights are optional, an investor has the ability to convert shares of preferred stock into common stock, typically on a one-to-one basis. Mandatory conversion rights are negotiable and require the investor to automatically convert shares of preferred stock into common stock through a process called “automatic conversion”.
- Employee Stock Option Pools (“ESOPs”) refer to the shares of stock reserved for employees. The ESOP is taken from the founder’s stock, specified as a percentage of the post-money valuation. Having a strong ESOP can help to attract top talent to your startup, with the chance for employees to earn stock once the company goes public.
- Dividends are payments made up of a distribution of profits from a corporation to its shareholders. Dividends can either be cumulative or non-cumulative.
Investor Rights & Protections
Some clauses of a term sheet are put in place to protect investors and their investments. Having these rights clearly established in a term sheet can help to ensure fairness in the investments and provide investors with greater security when investing in your startup.
Here are some examples of such protection clauses:
- Anti-dilution rights shield preferred investors in the event of a “down round”, or lower valuation than what they invested in. When a company’s valuation decreases from different rounds of financing, preferred shareholders are protected by receiving additional shares.
- Pro-rata rights give investors the option to participate in future financing rounds to keep their percentage ownership in the company that would otherwise be diluted. Pro-rata rights are typically given to larger investors in rounds and aren’t always enforced.
- Right of first refusal (ROFR) requires that current shareholders are notified and have the right to buy stock from an investor who is selling. This prevents secretive transfers of stock from occurring, such as an investor selling your stock to a competitor.
- No-shop clause establishes that the founder agrees to not shop the deal while the VC investor agrees to get things done within a reasonable time period.
Governance Management & Control
Term sheets also help to establish who is in control of the startup. This aspect of term sheets can include the following rights:
- Voting rights are the shareholder’s right to vote on company policy.
- Protective rights give investors the right to block or veto certain actions.
- Board rights establish a Board of Directors to represent the shareholders’ interests in the company. Most companies strive to create a balance in which neither the investor nor the founders solely control the board.
- Information rights promise that you will be sharing the company’s financial status regularly with investors.
Exits & Liquidity
Lastly, term sheets should specifically describe what happens in the event of a sale and shareholder rights during the process.
Terms you may need to know regarding exits:
- Drag-along rights prevent minority shareholders from blocking the sale of the company if it was approved by the majority shareholder or by a collective majority.
- Tag-along rights protect the minority shareholder by giving them the right to join in any action with the majority shareholder.
- Redemption rights give investors the right to demand redemption of stock within a certain amount of time.
Getting the best term sheet for your startup
When it comes to establishing a term sheet with investors, you want to make sure you’re getting what’s best for your startup. In the early stages of establishing your investors and deciding on terms, make sure to talk to more than one VC. Being able to gauge the overall interest of investors can put you in a better negotiating position and make it possible to push for favorable terms. You and the VC are not going to agree on everything, so being able to prioritize certain terms and push for your needs is important.
If it’s your first time creating a term sheet, it’s a good idea to work with an attorney with VC financing expertise. Working with an expert can provide you with the support and advice you need to be successful in your negotiations. It can also help you show VCs that you have the good sense to collaborate with experts despite your inexperience.
When looking for the right VC to invest in your company, Grasshopper is here to help. Grasshopper Connect is an exclusive platform that allows our startup clients to connect with a curated list of investors within our network. Open an Accelerator Startup Checking account today to gain access.
By Michaela Lenahan in Startups
