A term sheet is a non-binding document for both the founder and the investor. It outlines the terms and conditions involving an investment. There is no one-size-fits-all as to the structure of the term sheet but it has to have all the necessary details. Everything has to be laid out and all parties must agree to what is stated in the document before signing anything. Make sure you understand all the terms and conditions. It is recommended to take legal advice if you are in doubt.
For startups, it is imperative that you know what is a term sheet and why it's essential to your fundraising. The term sheet ensures that both parties - you and the investor - agree to the major aspects of the business transaction. It should have details as to what you are giving and what you get in return. The key is to make it simple and clear. Make sure that you cover everything to avoid misunderstanding.
The term sheet in itself is not a done deal yet. Due diligence needs to be done by both parties. Do not make the mistake of increasing all your expenses because you thought that the deal is closed. Unless it is signed by both parties, it is not a closed deal yet. Once both parties have agreed and the term sheet is executed, it's used as a guide for the final investment agreement.
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Types of Funding
An early-stage investment is called the seed capital. The funds are used for supporting the business until it can generate its own cash flow or ready for a bigger investment. Often, seed capital is a small amount as the business is still in the conceptual stage. Because it's risky, the seed capital is usually exchanged for an equity stake.
If they are not from either family members or friends of the business owner, seed investors can be those high net worth individuals called angel investors. Seed funding is the first financing you will acquire. The next step is the Series A funding from venture capitalists. If you want more capital, you can raise your Series B or Series C funding. Investors will be more interested in your performance and growth rate before they decide to invest. Take note that you will have to draft another term sheet for each funding.
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What to Include in the Term Sheet
There are different term sheets for Seed and Series-A series but below are the common things you need to include in the term sheet.
- Company details, founders and current shareholders
- Company valuation and how much it hopes to raise
- Any rights for founders, directors or investors
- Details on the amount offered and how the invested funds will be used
- Whether the investors have 'reserved rights' in respect of some major decision in the company
- Restrictions on activities of the owners or founders
- Summary of rights, what happens on liquidation
- Types of collateral offered
- Shares and price
- Conversion options
- Anti-dilution provisions
- Rights to future investment
- Who pays legal expenses
- Founder's obligations
- Non-disclosure requirements
- Signatures
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Term sheets should accurately reflect what has been agreed upon by both parties. Otherwise, issues may arise and that may cause uncertainties. As a startup, be wary of an investor who wants to impose a penalty in the event that the terms are breached. Also, you need to look out for debt financing or convertible note terms that may lead to bankruptcy, an investor who wants more control, terms that could limit fundraising and those investors who do not have realistic expectations. If you are in doubt, always consult legal advice.
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Term Sheet Key Terms You Should Know
As a startup, it's important that you know what these conditions are.
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Valuation
The company's valuation and investment determine what percentage of the company the investor owns. The valuation is the most important component of your term sheet as it says how much each shareholder gets when your company sells.
As an entrepreneur, it's best you approach this mindfully. If you want to create a win-win outcome for both, try to negotiate a fair valuation. Be a smart negotiator if you want to win the investors and build good relationships with them.
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Liquidation Preference
This is the investor's protection for preferred stock. While the investor would like to see your company grow, they need some hope to ensure that they do not lose their money. With the liquidation preference, they have the option to either receive their invested capital or convert their shares. When the company is sold, your investors may receive the same amount they invested or they can receive cash based on what percentage they own in your company. In the term sheet, do make sure that the amount is not more than what is invested.
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Option Pool
This stipulation sets aside shares for future officers, consultants, directors and employees. Your investor may want a portion of the cap table for future grants. For startups, it's best to compute this post-money and ask the investors to share in the dilution. In most term sheets though, the standard is to compute it pre-money.
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Participation Rights
Also called double-dipping, this is when the preferred stockholders get their investments back first and participate pro-rate meaning that every shareholder will get an equal proportion for each share that he owns.
For example, the preferred stock has a $400k liquidation preference and he has participation rights. He also owns 30% of the cap table. If your company sells for $900k, preferred takes their $400 plus 30% of the remaining $600k with them getting $580k. That leaves $320k for the common shareholders.
This is not the standard so you can definitely negotiate for no participation rights. If your investors insist, get on a reasonable compromise by negotiating for a cap on participation. This will put a limit on how much they can double dip.
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Dividends
This provides an additional return to the preferred stockholders and dividends increase over time. In the term sheet, you most likely will come across terms such as "noncumulative" and "when as declared by the BOD." The word cumulative guarantees your investor a certain level of return and this isn't a standard feature. You need to also watch out for PIK or paid in kind which means that the dividend is paid to your investor through additional preferred stock. This dilutes founders and also increases liquidation preference for the preferred stock.
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Anti-dilution
Anti-dilution protects your investors from getting diluted in a down round. Its protection comes in many forms such as narrow-based weighted average, full-ratchet and broad-based weighted average. As the founder, you are safe with a broad-based weighted average.
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ESOP
This is called the Employee Stock Option Program which allows the employees to buy shares of the company at a subsidized price. Its main objective is to incentivise employees with shares that may be valuable in the future. This can be anywhere between 5 to 20% of the owner's equity. In the term sheet, make sure you discuss this with the investor to make sure that you are aligned.
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Reserve Matters
This is a list of matters done only with the investor's consent. It includes limiting the owner's ability to acquire cash from the business except for what was agreed. You can negotiate with the investor if you think certain matters may not be reasonable especially when it makes it difficult for you to run your business.
Series A Term Sheet
For a Series A Term Sheet, what's usually included are the liquidation preference, Series A preferred stock, voting rights, compensation of the board of directors and the employees and the drag along with rights.
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Due Diligence
Some investors use this process to expose company weaknesses, liabilities or threats that may affect their investment. As the founder, make sure that you are transparent and you respond to request for documentation quickly.
In the Series A stage, some investors criticize the metrics like the revenue figures. They may even talk to your actual customers. Always present any complaints, lawsuits, infringements or anything that may come up. Some of the reasons why deals are not closed is when the investor loses trust in the founder.
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Final Advice for Startups
Before making a decision, investors would want to know how much control they can have over the affairs of your company and the investment, and how they are able to get a return on their investment. In addition, they definitely would want to see your business plan, your competition, team, experience, the product or service and the target market. As a startup, it would benefit you when you are able to craft a good business plan including your marketing strategy. Your investor would like to know how you also plan to grow your business.
In addition, it would help if you have a clear presentation for your investor. Get the right message across to your investors with a visually appealing presentation complete with all the details they need.
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