Term Sheets and Startup Investments
In this article, we cover 3 main questions regarding term sheet and startup investment. First, “What is a term sheet?”. Second, “What are the elements in the Term sheet?”. And lastly “What are the crucial points of Term sheets where we should focus on?”.
Usually, term sheets are made for the funding. Not only that, but you may also find term sheets differing after every investment or funding rounds.
Since now we have a basic idea about the term sheet lets go into detail to find out “What are the term sheets?”
In simple words, a term sheet is a document that includes all the basic elements of the company. A term sheet is generally a non-binding agreement. This shows the basic terms and conditions of an investment. In other words, term-sheet serves as a template or a base on which further legal documents might be made. However, term sheets aren’t enforceable by law.
Important Key points related to Term sheets:
- A term sheet is a non-binding agreement (legally not enforceable). That provides an overview of the basic terms and conditions under which an investment will be made.
Furthermore, Term sheets are mostly for startups. Generally, entrepreneurs feel that this document plays an important role in attracting investors. This includes Venture Capitalists (VC) with capital to fund enterprises and other investors.
Term sheet includes the valuation of the company, investment amount, percentage stake, voting rights, liquidation preference, anti-dilutive provisions, investor commitment, and similar details related to investments. In other words, the term sheet should cover every aspect of the company’s business.
Following is the draft which might give an overview of how the Term sheet looks.
How to read a Term sheet?
Since now we know what is term-sheet, we move forward to understand the elements of it. For an inexperienced or a fresher, the first look of a Term sheet might send a person into a spiral of confusion. To read a Term sheet one should know Basic Glossary related to the term sheet. Following is the list of glossaries that will help us understand how to read a Term Sheet and startup Investments.
Investors: Investors are the ones who are investing capital in the company.
Amount Raised: It refers to the amount of capital raised till the date by the company.
Price per share: Price of each share. A startup might have 100 shares, then 1 share equates to 1 percent equity in the company.
Pre- Money Valuation: It refers to the valuation of the company before the investment.
Capitalization: Company’s total share multiplied by the Share price.
Dividends: Dividends refers to the distribution of profits to its shareholders.
Offering Size: How much percentage or of what value the company is offering to sell the company share to investors.
Liquidation Preference: This refers to the flow in which the capital invested will be repaid to its stakeholders in case of liquidation.
Voting Rights: This part Highlights that whether the investors have a vote in the internal decision making or they don’t. And if they do, then to what extent.
Use of Proceeds: This segment usually includes the plans of the company. Furthermore, it also explains how the company is planning to utilize the following amount.
Board of Directors: Body of elected or appointed members who jointly oversee duties that are outlined in the company’s charter.
Founder’s Stock: Further, this clause takes into consideration shares of common stock that are issued to founders at the formation of the company.
Lock-up Period: This clause restricts the sale or transfer of shares.
Conditions to Closing: It includes the task which must be completed before the completion of the investment.
Protective provision: This includes Veto rights that investors might have on certain decisions by the business. For instance, raising further capital.
Anti-dilution Provisions: This clause protects the investor’s interest by blocking any possible dilution of its shares in future rounds of investment.
Mandatory Conversion: This clause highlights what part of the capital needs to be converted in the future. For example, a company may add a clause regarding preference shares of investors that need to be converted into common equity shares when the company goes public.
Redemption Rights: This clause shows whether the capital invested in the company is redeemable or not. Furthermore, if redeemable then when? Usually, debts are redeemable, but equity is not redeemable.
Demand Registration: Usually, this clause is generally added by investors. Furthermore, this clause enforces the company to make it’s stock public so that it can resell it. Usually, resell in secondary market.
Right to Participate Pro Rata in Future Rounds: This clause highlights an investor’s right to continue to participate in future rounds so they can maintain their percentage ownership.
Matters Requiring Investor Director Approval: In this part business generally identifies the crucial business. Furthermore, they also decide what decisions would require consent from the investor representative on the Board of Directors.
Non-Competition and Non-Solicitation Agreements: In this clause, neither party is allowed to start a similar business. Furthermore, it adds restrictions to enter into a partnership with other similar businesses
Non-Disclosure and Developments Agreement (NDA): NDA is an agreement to not pass along confidential information to an external party about the business or its products or services. Similarly, it also restricts the parties to share the development policies or plans to a third party.
We can now come to the last part where we see exactly “what to read in term sheet”. In other words, we will look at the crucial points of the term sheets and startup Investments which we must take into consideration. The following are the segments of term sheets that must be looked into.
Valuation is one of the most important or significant items in the “Term sheet and startup Investments”. Furthermore, it has a great impact on the decisions of the investment.In particular decision regarding buying ownership stake. There are mainly two ways to value a company i.e, ”pre-money” and “post-money”. Pre-money valuation is a companies valuation before the investment. While post-money valuation is the valuation of the company after the new investment.
When it comes to valuations, higher valuation doesn’t mean better investment opportunities However, we must understand that bigger or higher valuation does not necessarily mean that it is a great company. A higher valuation cannot neutralize its other shortcomings. Furthermore, parameters used for valuation shall also be taken into consideration.
Another significant segment to keep an eye on while going through the term sheet is Option Pool. An option pool can be described as a block of the company’s equity that has been kept aside mostly for employees of the start-up company. Option pools can be anywhere between 15-25% of equity. However, adding an option pool will tend to dilute the shareholdings of founders and early investors or employees over the period. Not to mention that the option pool can have a great impact on Valuation.
In addition to this, the timing of adding an option pool also has an impact on the valuation. For example, if the option is added in pre-money valuation then it is beneficial to the investor. In case, the option value is added in pre-money only then it’ll dilute shares of previous shareholders. While in case of it being added to post-money valuation, both previous, as well as new shareholders’ shares, will be diluted.
Board of Directors
As the Board of Directors play a large role in corporate governance. They are like the brain behind the decision, which has a great impact on the future of the company. Ideally, for an early-stage company, the representation of investors and common stockholders should be proportional to their control of the capital invested. A common example for an early stage board of Directors will be a three-person board consisting of two founders representing common stock and one investor.
Liquidation preference lays out in what order and how much of the return the investors will receive when the company will liquidate. For instance, the sale of the company. In other words, it will show the flow of funds through its stakeholders. For Instance, let’s assume a VC firm invests $10 million in a startup or a private company. In exchange, it receives 50% of the common stock and $5M of preferred stock with liquidation preference. Assume also that the founder of the startup or the company also invests $5,000,000 for the other 50% of the common stock. Now suppose in future they sell the company for US$ 30 M. Then, the VC firm will receive $20 million, being their preferred $10M and 50% of the remainder, while the founders receive $5 million.
In addition to this, suppose if they sell the same company for $ 5 M. Over here, the VC firm receives $5 million and the founders receive nothing.
Protective Provisions are separate class voting rights. Especially, for the company’s investors holding shares of preferred stock. These provisions provide investors with greater control over the company. Even if they don’t own a greater part of the stock in the company.
Protective provisions, or “veto rights,” for investors over certain corporate actions are usual. However, some can be to your detriment. For example, one should be cautious of in particular is a veto right on future financing – this can be tough to locate. In fact, this may be included in a simple phrase like “no amendments to the certificate of incorporation without investors approval”. The word of law here can be tricky for a layman, so it’s in your best interest to review these closely with someone with legal knowledge.
Anti-dilution protection guard investors against the future sales of preferred stock at a lower valuation than its current or initial value. These protections are very common and generally added particularly for preferred stock. However, they are not set, they can vary in the extent to which they protect investors. There are various ways an investor can protect their share. For instance, “Broad-based weighted average” anti-dilution protection is fairly mild and essentially states that some amount of anti-dilution shares will be issued if the company issues additional equity securities.
This research article has been produced by Investocracy, a company focused on connecting startups from emerging markets with Japanese investors.
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