Many founders still have difficulty understanding certain clauses in term sheets despite the increase in resources available to help them navigate the fundraising process.
These clauses could lead to the founders losing control over their company or even payout structures if they decide to exit. This article explains the most important clauses in the term sheet and their implications.
Prepare yourself for a negotiation, not a ransom.
Numerous efforts have been made to outline what a neutral term sheet should look like (e.g., Y Combinator SAFE Finance Documents, NVCA term sheet template resources). Founders must familiarize themselves with this material because an investor will usually be the one to present the first draft of a term sheet.
A rare sheet contains aggressive terms that penalize entrepreneurs. Investors know that aligning founder and shareholder interests is crucial to achieving a high return on investment.
There are cases, however, where a founder can unknowingly lose control of their business or its economics due to certain clauses contained in the term sheet. The article describes the potential pitfalls and consequences that may arise when using this terminology.
N.B. This article is primarily aimed at founders, but it can be a valuable resource for startup employees who receive stock-based compensation.
Pre-fundraising: Initial Homework
It is important first to highlight the groundwork needed before diving into the specifics of the terms sheet clauses. When asked for advice on fundraising, I am most often asked to give my opinion about the following areas.
Figure Out Vesting
Before entering into negotiations with external investors, ensure that you have a vesting plan in place. If a founder leaves suddenly, they may leave vested equity on the cap table. This can have a significant impact on the efforts of other founders. This is a guide that will help you get started.
Investors: Get your ducks in a row
It is a great way to evaluate your worth. Compare the two term sheets separately to get a better idea of how investors view you. If an investor notices that you have put all your eggs in their basket, they may be more willing to negotiate with you.
Adapt to mismatched investors.
When a startup receives seed funding from a renowned early-stage V.C. or angel fund, it is likely to be a smooth process, and there should be no surprises. If a late-stage investor or a corporation that is new to the game is investing, there will be more legal issues to work out.
Do Your Own Due Diligence
Consider the due diligence process in relation to your investors as a joint effort. It is important to look beyond their financial resources when evaluating an investor’s credentials. Selecting investors is a way to choose long-term partners that will play an important role in your business’s development. Do your research. To get you started, here’s an article.
You Should Be Careful When Valuing Your Home
Anyone raising funds must understand the concepts of before-money and after-money valuation. Even a slight slip-up can have a significant impact on ownership percentages or economics.
Know how your company’s valuation compares to other companies. A high valuation will certainly demonstrate external validation and a stronger paper wealth. It also increases the performance bar if you wish to progress to the next round. This is also known as the ” value trap.”
Get Neutral Advice
Lastly, if you are dealing with other parties outside your company, hire an attorney who has a proven track record. Make sure that you make the decision yourself about whom to hire. Do not always follow the advice of your investors. The article provides some helpful insights on how to tackle the legal side.
Terms Sheets: Details You Should Know
We can now get into the specifics of the clauses in the term sheets that cause founders the most problems.
The mechanics of preferred stock
Investors in the early stages of their careers tend to invest in preferred stocks. Preferred stock is an entirely different equity class from common stock. It’s the premium economy to cattle class. Investors can add terms and conditions to their stock classes that are not applicable to other shareholders. You can see this at IPO times when voting rights are often unevenly distributed.
In the hierarchy of debtors, preferred stock is above common stock, and so its holders are entitled to receive their money before other shareholders. This is often a formality in a successful sale scenario. However, when the company is distressed, it can make a big difference.
The clauses in the term sheet described elsewhere will, therefore, only apply to the preferred stock class that your investors create when they invest money in your company.
Dividends to Reappear in the Future
Preferred stock has a fixed percentage of dividends (yield), which is due to the bearer. Dividends are periodic payments of profit shares, most often associated with blue chip stocks. Startups tend to recycle cash flow into their business. There are very rare exceptions.
Three options are available for negotiating preferred stock dividends on term sheets for startups:
” discretionary “: Dividends will be paid if the company chooses.
” Fixed “: Dividends guaranteed are paid out periodically in cash or stocks.
” Cumulative “: A cumulative dividend right must be attached when dividends are due each year and paid upon a liquidation.
Below is an example of rhetoric from the NVCA Term Sheet Template.
All financings are done on a case-by-case basis. Be aware that the obligations for the other options will increase the economic considerations owed to investors relative to their original cash investment.
Liquidation: The Hidden Iceberg
Liquidation Preference is one of the most common clauses in startup term sheets. Liquidation preferences, as the name suggests, determine the payout hierarchy upon a liquidation, such as a sale of the company. Investors can define their initial payout amount by using liquidation preferences. Take a look at an illustration.
A 1x preference for liquidation means that investors will get 1x their original investment back. If your investors invested $10 million in your company and it is sold for $11,000,000, they’ll get their $10 million before anyone else. This hurdle would be raised to $20 million with a 2x preference.
