Key terms to ensure your deal is a fair one
The Term Sheet is the most important document when investing in a startup. This legal document sets the terms for the current funding round and lays the foundation for terms set in future rounds, making it crucial to get the negotiations right. These negotiations can be lengthy, as lawyers’ involvement and differing priorities can create back and forth amongst the negotiating parties. If you know what to focus on, you can speed this process up. So today, we will look through some terms that take priority.
Term Sheet Basics
What is a term sheet? It’s the legal document that sets the specific terms for the investment deal. How many shares is the VC buying? At what price? Who sits on the board? The term sheet outlines all of these things and more. VCs create term sheets for every institutional funding round. In later rounds, they can get more complicated with more investors on the cap table and include more advanced investment structures, such as venture debt, warrants, and conversion of notes in earlier rounds.
Before we get into some specific terms, there are some high-level notes to cover that will be helpful when thinking about term sheets:
- Venture Deals, one of the best venture capital books, discusses term sheets in-depth and breaks the focus into two categories of terms: economic terms and control terms. I will use the same approach to keep things simple.
- Disclosure: I get a kickback if you purchase through that Amazon link.
- Some terms, and the ability to negotiate them, are set by the market. When VC money is scarce, it’s an investor’s market, and they have more power to set terms. When there is a lot of liquidity in the market (as there is today), it’s a founder’s market as they can take the deal to another investor, giving the founder more negotiating power.
Based on the economic terms in Venture Deals, I will list them all but only go in-depth on a few of them.
- Valuation & Price: Likely the most essential term on the Term Sheet. What is the company worth? The valuation sets the price per share and determines the amount of ownership each shareholder has. I did a post on determining valuations, which you can read here.
- Option Pool: Pool of shares available to be granted as options, typically held for employees of the company.
- Warrants: A right for an investor to purchase a certain amount of shares for a predetermined price for a certain number of years.
- Liquidation Preference: Determines the order and amount in which money is paid back to investors during a liquidity event. This term is downside protection for investors. An investor with liquidation preference gets their money first, typically a certain multiple of their original investment.
- There are two types: participating and non-participating. This topic deserves a separate, which I will publish soon.
- Liquidation preference is a hotly contested term. In a founder’s market such as today’s, this term is typically “founder-friendly” and will be a 1x non-participating.
- Pay-to-Play: A provision stating that investors must use their pro-rata in future funding rounds to avoid converting to common shares
- Vesting: The schedule determining the transfer of ownership of stock options to an option holder (usually an employee). The typical plan is four years with a one-year cliff.
- Antidilution Preferences: A clause allowing the investor to maintain their ownership percentage in a company. This term comes in handy as the capitalization table expands or a company goes through a “down round” at a lower valuation.
- Pro-rata: the right for an investor to participate first in future rounds of financing
- There are two types of antidilution calculations: Weighted Average and Full Ratchet. I will cover these in a future post.
- Board of Directors: Who sits on the board and has voting rights. Aim to have a good balance between founders, investors, and independent third parties.
- Protective Provisions: Veto rights that investors have on company actions.
- Drag-Along: A provision that states an investor must have a minimum amount of shares to count as a vote or otherwise gets “dragged along” with the majority.
- Conversion: The specifics around the transformation of shares from Preferred Stock to Common Stock.
There are many resources available for researching term sheets. First, NVCA (National Venture Capital Association) has free Term Sheet templates that your firm can use. I highly recommend using these to keep things simple and save on custom legal documents. Also, Y Combinator offers excellent templates for early Seed-Stage companies that are raising money through convertible notes and SAFEs instead of institutional venture capital. Lastly, Wilson Sonsini offers a free Term Sheet generator where you can play around setting up a document with your custom terms.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.