The Legal Viewpoint: What Startup Founders Raising Capital Need To Know About Term Sheets
We explore the fundamentals of term sheets, decode some term sheet jargon, and highlight some red flags to watch out for, so you can be ahead of the game, and be term sheet-ready.
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As a startup founder raising capital, negotiations with investors are bound to extend to more than just the actual investment amount. Before you reach this point, it's good to have a clear understanding of the term sheet- a key document that lays out the agreed terms of the potential deal.
Term sheets are non-binding legal agreements. Once the term sheet details are agreed, parties incorporate the terms into a subscription agreement at a future date, which then becomes a binding legal agreement between founder and investor. Clearly, a term sheet is central to negotiations, and it keeps both parties on track to progress the deal to a successful conclusion. In this article, we will explore the fundamentals of term sheets, decode some term sheet jargon, and highlight some red flags to watch out for, so you can be ahead of the game, and be term sheet-ready.
PART ONE: WHO CREATES THE TERM SHEET?
Typically, investors will provide a term sheet when they have reached the decision to invest in your startup. If you are at an early-stage family and friends or seed round, then you can certainly provide a term sheet to an investor, who may be impressed that you have all your ducks in a row. As a startup founder, your focus is on retaining as much equity and control over the company as possible, so take some time to consider what you are willing to exchange for investment before you create or negotiate a term sheet.
- What is the valuation before the investor invests (pre-money valuation)?
- What amount do you need to raise to reach your next big milestone?
- Are you likely to raise more capital in the future (leading to further dilution of your shareholding)?
- What does the investor bring to the table, other than the investment itself (i.e. relevant experience, networks, and/or commercial acumen)?
PART TWO: WHAT IS INCLUDED ON A TERM SHEET?
When your startup requires funds to get off the ground, or, at a later date, when your company needs capital to sustain operations or expand, a term sheet is required. Here is what most term sheets should include:
- Founder /Investor Information Details about the business owner and investor to show which parties are involved in the term sheet.
- Valuation Declares how much the company is worth. This can also include information on any shares issued, and the price per share. Obviously, the valuation is of primary interest to investors.
- Investment Amount Ensure that this is clear in terms of the amount you are expecting as an investment.
- Percentage Stake Outlines the percentage of ownership the investor will hold if the deal goes through.
- Timeframe Standard practice to specify a certain period of time the investor has to examine the term sheet, and then make a formal decision.
- Voting Rights Venture capitalists may want to secure voting rights in the company to maximize their return of investment (RoI) potential. If you are a startup founder drafting a term sheet, it can be difficult to predict which way this will go in terms of the agreement. However, you can outline the level of voting rights the investor will hold.
- Additional Provisions These typically include an investor's right to company information and future investments, nondisclosure details, founder's obligations, and identification of who is responsible for paying any legal fees. Another important point is that the term sheet should clearly state that it is a nonbinding agreement. This allows both the entrepreneur and the investor the opportunity to walk away from the deal prior to any legal paperwork being completed.
Related: The Legal Viewpoint: How To Structure Your Startup For Success
PART THREE: WHAT SHOULD YOU LOOK OUT FOR ON A TERM SHEET?
Term sheets can include a fair amount of jargon, that may make you feel overwhelmed.
Here are the more common terms you can expect to see on a term sheet, with clear explanations:
- Valuation The valuation of how much your company is worth is broken down into two terms: pre-money valuation and post-money valuation. Pre-money valuation is the value of the company before you received the new investment, and post-money valuation is the value of the company after receiving the new investment. Ensure that you and the investor are clear as to whether you are talking about pre-money or post-money valuation, as any confusion will impact the size of equity stake your investors receive, due to the fact that this affects price per share.
- Drag And Tag-Along Rights When a company sale is on the horizon, these rights can be exercised, which ensures balance in terms of the competing interests of minority and majority shareholders. For startups, the majority of equity is owned by founders, and minority shareholders are investors. The drag-along clause states that across major business decisions or in the event of the sale of the company, minority shareholders are required to follow the lead of major shareholders. Usually, this would equate to three-quarters of shareholders being required to invoke this right. Most buyers are looking to purchase the entire company, so this right eliminates the risk of a select few shareholders blocking the business sale. Conversely, tag-along rights protect the rights of minority shareholders in the event of being sold. If the majority shareholder organizes an exit share sale, tag-along rights allow minority shareholders to sell their shares at the same price as the majority shareholder.
- Dividends Based on company profits, shareholders are paid dividends, usually on a quarterly basis.
- Pro-Rata Rights These are the rights an investor has to take part in funding rounds in the future. This can also include provisions that specify investors have to take part in investment rounds or pay a penalty (pay-to-play).
- No-Shop Agreement This term limits your ability to form relationships with other investors after the term sheet is signed. You would normally wait a period of time before completing another fundraising round, and you'd include an expiration date after which you can seek additional investments. In an ideal world, any investments in your company will be smooth, uncomplicated, and benefit both parties.
However, some investors may try to institute various provisions that are detrimental to you as the company founder. Here are some red flags you should be aware of:
- Significant Controlling Stake Beware of investors requesting a large stake that will give them the biggest share and basically control of your company.
- Unfair Financing If the investor specifies that the investment is a loan for your business expenditure, check the loan terms are fair, so that you don't become bankrupt by trying to repay the debt.
- Limiting Terms An investor may try to put a limit on the amount of fundraising you can secure in the future, potentially not a beneficial option for your business down the line.
PART FOUR: THE LAST WORD
Well-drafted term sheets are a critical step toward securing investment; therefore, it's important to understand how they work as well as the benefits they offer your business. Watch out for red flags, such as an investor requesting a large stake in your business, offering unfair financing terms, and/or limiting your fundraising activities in the future. While not a binding contract, a term sheet will help you be on the same page as your potential investors, and save you a lot of time, money, and stress.
Related: The Legal Corner: To Raise, Or Not To Raise? A Lawyer's Guide For Entrepreneurs Seeking Funds To Grow Their Startups