Raising funds is an essential step in developing your start-up. Deciding how much to raise is a balancing act. If you raise too little, you will have to go through the effort of another fundraising round; the more you ask for, the more advantageous terms investors will seek.
How much you can raise also depends on the valuation of your company.
As part of the fundraising process, you will negotiate a term sheet with your investors. This is a key part of the investment process.
All terms are negotiable. Some terms are investor-friendly, whilst others will be more favourable to founders. Either way, you need to understand the terms. The term sheet forms the basis of your deal.
What is a term sheet?
A term sheet is a relatively short document setting out the key terms of the investment agreed upon between the company and the investor in user-friendly language. It is also referred to as a Memorandum of Understanding (MOU). It includes the business and finance terms and could include legal terms regarding confidentiality and dispute resolution.
Essentially, a term sheet is the basis on which the final investment agreement will be based. Although all terms are not necessarily legally binding, it is critical that you get the term sheet right. It lays the foundation for the final legal documents.
Founders should attempt to take the lead and prepare the term sheet. That way, you keep control of the negotiations and your company.
If the investor is a lead investor, they might prepare the term sheet. As the founder, you must make sure that you understand and agree with all the terms, in particular, the company valuation, the rate of dilution, and all terms that grant a measure of control to the investor.
Key terms to look out for in a term sheet
Typically, you will find the following terms in the term sheet. Whether you are the founder or the investor, you should know what these terms mean and understand the implications of each one.
• Company Valuation
The company’s valuation and the amount invested will determine what percentage of the company the new investor will own. Investors want to see the company’s valuation. You need to understand the difference between pre-money (the company’s value before receiving the funds) and post-money (the estimated value after receiving the investments) valuation. The term sheet must clearly state which valuation the negotiation is based on. As a founder, you need to understand that if the valuation is too low, the risk of diluting founder shares is higher. The higher the valuation, the tougher the terms investors seek to achieve their desired returns.
• Investment Amounts
Since investment amounts determine percentage ownership, accuracy is critical.
• Type of Shares
Shares can be broadly classified as common or preferred. Preferred shares give investors special rights, such as liquidation preference. Founders and employees usually have common shares. The term sheet should set out the types of shares and the share class rights.
• Share options
Are usually reserved for employees. It is also called Employee Stock Option Pools, or ESOPs. It is used to attract talent to a start-up. ESOPs are typically taken from the founder’s shares. Investors are usually interested to see what is available to attract talent.
Preferred investor rights
• Liquidation Preference
The right to be paid out first if the company is liquidated or sold. Liquidation preferences is an important term to consider. Preferred shares that include liquidation preference is more valuable than common stocks. Investors want to know in which order they will get paid out in the event of liquidation or if the company gets sold.
Distributions of profit from the company to the shareholders. Investors may want to know upfront what dividends they are entitled to. Dividends can be cumulative or non-cumulative. Some preferred shares could include a right to cumulative dividends, meaning dividends are calculated every year, and if the company can’t pay, it accumulates to the following year. Non-cumulative dividends don’t carry forward to the next year if not paid. For founders, non-cumulative dividends are better.
• Conversion Rights
Is the right to convert preferred stock into common stock. Conversion rights can be optional or mandatory. Mandatory conversion refers to an “automatic conversion” process where shares of preferred stock are automatically converted to common stock. These rights are negotiable. Optional conversion rights allow the investor to convert preferred shares into common stock. Whether the investor will exercise this option often depends on whether the investor wants liquidation preference.
• Anti-Dilution Protection
Protects the investor’s percentage ownership of the company in future financing rounds. If the company’s valuation decreases, anti-dilution protection can include preferred shareholders getting additional shares to protect their percentage ownership. Founders should be careful of such terms since they will have to carry the dilution.
Some terms are included to control and manage governance. Control terms include the following:
• Reserved Matter Rights
The term sheet might set out a list of matters that require special approval or consent. An investor may require that some board decisions can only be made with the approval of the board member appointed by the investor. As a founder, you want to limit these matters.
If the majority shareholders approve a transaction, drag-along rights prevent minority shareholders from blocking the transaction from happening. Investors may want to know that a minority shareholder will follow the decisions made by the majority stakeholders. It also means a deal gets offered to everybody on the same terms.
• Board Member Appointments
Investors might seek the right to appoint a board member to have more control. Founders should take care – if you lose control of the board, you lose control of your company.
• Founder and Employee Vesting Schedules
Vesting makes it challenging to leave the company. How and when shares vest can be an incentive to stay. However, if the agreement says employees must return all shares if they leave, the company can find replacements. Founders should attempt to exclude part of their holding.
The term sheet should explicitly state which terms are binding. Certain terms, such as exclusivity, are typically binding from the start of negotiations.
• Exclusivity - exclusivity provisions restrict the company from dealing with other investors for a defined period. Exclusivity terms are not founder-friendly since it limits the founder’s ability to negotiate with other investors for a specified time.
Other rights that could be included are:
• Pro-Rata Rights
Pro-rata rights allow investors to participate in future financing rounds to maintain their percentage ownership instead of facing dilution. Founders must understand if and how it affects their risk of dilution.
• Right of First Refusal
Investors might want the right of first refusal when new shares are issued since it could protect them against dilution. They might also want the right of first refusal to buy departing investor or founder shares.
If you are a founder, term sheet negotiations are about raising funds while keeping as much control as possible over your start-up or venture. Investors will become a critical part of your start-up. How they negotiate says a lot about investors. Will they be an asset to your start-up? Do your own due diligence before accepting an investment. Good investors will do their due diligence on you and your start-up.
The term sheet will form the basis of your deal. It might be prudent to get professional advice before preparing the final documents. If you are a founder, you want to consider investor-friendly terms carefully, and investors must carefully think about founder-friendly terms. Professional advice can point out any negative consequences for either party.