Venture Capital Term Sheet Guide
New business founders may have encountered the word term sheets in their business dealings. Some may have understood its definition but don’t truly understand what it can do to their business. Discussing what term sheets are can be quite detailed, but we have simplified what it means in this article.
In a general sense, term sheets are not exactly a binding contract unless you specify otherwise. Although, there can be an exclusivity provision that will restrict the business founders from negotiating and seeking other potential investors in a set time. Typically, the business founders cannot seek negotiations within 30 to 60 days once the term sheet is signed. To give you a more extensive discussion of term sheets, we’ve listed some of the basics you must know.
What is a term sheet?
The written document where the most critical parts of the terms and conditions of a business deal are what makes a term sheet. It serves as a document that summarizes all the most important points of the agreement agreed upon by both parties. The term sheet comes before the actual execution of the legal contracts and beginning with the due diligence that will certainly need more time to accomplish.
In the subsequent meetings, the term sheet will serve as a template for both parties’ legal teams in drafting a definitive agreement. Although, this does not have the same power as legal documents. The term sheet alone is non-binding since it only reflects an overview of both parties’ agreements.
What happens in a term sheet negotiation?
As a startup founder, you would want to seize every opportunity you could to ensure that your company will thrive. One of the most crucial things you need to think about is your business capital. It is your goal to have as much capital to work with and maintain and control any possible downsides that may limit your operations.
The role of the term sheet is to disclose both the benefits and risks that the parties will encounter. In order to disclose this information, there is a need for multiple standard clauses. One situation may vary from one business to another. However, one thing is certain, that both parties understand all these clauses that are included in the term sheet. When both parties understand both the upside and risks to which they will be subjecting themselves, they are better informed. Having all the necessary information allows both business owners and investors to arrive at the best decision. Another advantage that comes with a term sheet is the chance to get to know your investor a little more. The terms and conditions that you will agree upon can easily spell what kind of relationship you will have with them. Observe what your investor will push for and what they wouldn’t.
What are the most important clauses in the term sheet?
Perhaps the most important terms that you need to focus on are our investment and valuation in the business world. Remember, everyone who ventures into business has one main goal: to earn at the least amount of risk. You will notice how the investors you are negotiating with will attempt to minimize their risks at every turn while also setting themselves to maximum returns.
Some business owners may think that valuation is more important than a deal, but that is not always the case. Typically, a term sheet has four categories, deal economics, the rights and protection of the investor, governance management and control, and exits and liquidity.
The deal economics answers the question of who gets what? Imagine a pie being divided into pieces. Normally, people want to get a small part, but it should come from a big pie. Both negotiating parties will want to protect their grounds. For the investor they will want to use special clauses to do that.
As a business founder, be critical of the investment amount. Usually, the term sheet will specify each of the amounts the investors will provide. The following consideration is the valuation. You have to ensure that both of you are on the same page. Although, the valuation may differ in terms of the pre-money and post-money. The pre-money is the initial value of your company minus the funding you hope to raise. On the other hand, post-money is your company’s value once you have received all the investments.
Rights and Protection
In this clause, the one you need to focus on is the anti-dilution provision. When a company creates more shares which in turn decreases the existing shareholder ownership, dilution occurs. Having an anti-dilution effectively protects the investors from having smaller returns.
The pre-emptive rights also provide the investors with the right to maintain the level of ownership they have in the successive financing rounds minus the obligation that comes with it. The pro-rata rights are typically what most investors ask for, especially for hot start-up companies in the market.
Governance management and control
Though the term sheet may not be as comprehensive as legal documents, it has to determine who controls the business. It is critical to include the board rights, voting rights, rights to information and founder vesting.
Voting rights mainly focus on a shareholders ability to vote on the corporate policy. Typically, the voting rights of a shareholder will cover the issuance of securities, liquidation of the company and a sale, and annual spending budgets and exceptions, just to name a few. On the other hand, the board rights are for the board of directors who represent the shareholders. Their rights include hiring and removing senior executives and executive compensation as just some of their main rights. In addition, for the board to arrive at the best decision for the shareholders, they need information rights. Usually, the board rights are coupled with information rights that will allow them access to both the business and financial condition of the company, which is given to them regularly.
Finally, the founder investing is like a safety blanket for the investors. Though there are already business risks, there may also be personal risks. As the business founder, one day, you may just want to walk away once you’ve achieved your goal. However, with founder vesting, the investors are minimizing the possibility of losing the founder by making it difficult and even painful to leave. The founder is far from its employees, and it is critical to ensure that you remain in the company. Although, you can still work with the investors to find common ground if you want to have an early retirement.
These key factors are just some of the basics any business founder should know when dealing with term sheets. It is best to research further and ask for legal advice to examine the finer details of your term sheet, which will, later on, be a part of the due diligence of your business.