Deciphering an Investor Term Sheet

Talar Demirdjian, Jun 08 2017

Term sheets can be quite confusing for founders when dealing with a venture capital investment, and although not legally binding, it can be hard to renegotiate terms once a deal is made. Therefore, understanding the terminology of a term sheet is necessary to comprehend what one is signing up for.

What is a ‘term sheet’?
Sometimes called letter of intent or even heads of terms, the term sheet defines the agreed position on all material commercial points and provides a sketch to draft the legally binding agreements. It basically dictates who gets what financially, and who gets to do what legally, in almost every scenario. This can come in various shapes and sizes, ranging from a bullet point document to a formal letter, but the purpose of these documents is the same.

An investor will prepare a term sheet to propose its investment terms to a company, and then to negotiate and agree on the deal points. Once agreed, it is used by the investor’s lawyers to prepare the first drafts of the main investment documents.

Terminology

Valuation
The company’s worth or ‘valuation’, including the amount of money invested, regulates the percentage of the company the new investors will own. Valuation is defined in terms of pre-money and post-money values. The pre-money valuation is the company’s valuation before the new investment. The post-money is basically equal to the pre-money valuation plus the amount of the new investment. The founder’s objective should be to maximize the amount of capital investment while minimizing dilution (a reduction in the value of a shareholding due to the issue of additional shares in a company without an increase in assets). However, it should be known that venture capitalists can extract more value than the valuation would imply, so the best deal isn’t necessarily the one with the highest valuation.

Liquidation Preference
Investors favor the success of your company so their stake in the company would be worth more than they invested. But if the company doesn’t succeed, a ‘liquidation preference’ gives them assurance of not losing all their money. Typically, preferred shares will be entitled to a ‘multiple’ of their investment back prior to any other class of shares participating in the proceeds available. The ‘multiple’ is typically one (1) times but can be two (2) times or, in exceptional circumstances, an even greater multiple. However you write it, make sure that the preference is not more than the invested amount.

Participation Rights
Some shares are eligible to participate in the balance of proceeds, they are called “participating” and if they are not eligible to participate, they are called “non-participating”. Participation rights let preferred stockholders regain their money before anyone else, and then also to partake entirely (pro-rata) in any remaining proceeds. Usually, from the founders’ and other shareholders’ perspective, it is preferable if the investors’ shares are “non-participating”. 

Dividends
Dividends, conveyed as a percentage (e.g., 11%), offer an added return that accumulates to preferred stockholders over time. Rights to preferential fixed dividends can be cumulative (meaning they accumulate as a debt until such time as the company can legally pay such dividends) or non-cumulative (meaning the dividends are only paid if the company is legally allowed to do so, but otherwise, do not accumulate).

Anti-dilution
It protects investors from getting grossly diluted in the event of a “down round”; a future fundraising at a valuation which is lower than the valuation at which the investor is investing. Anti-dilution protection comes in a couple of forms: full-ratchet, narrow-based weighted average and broad-based weighted average. The latter being, the most founder friendly form of anti-dilution.

Option Pool
The Option Pool refers to the investors wanting some percentage of the cap table to be set aside for future grants, but they want current shareholders to consume all the dilution.The founder friendly approach would be to calculate the option pool post-money and push the new investors to share in the dilution. However in reality, the customary for most term sheets is to calculate it pre-money.

Board of Directors
This must be the most familiar term so far, but don’t underestimate its importance. The board is a crucial governing body in any company, and term sheets will often include provisions on how it will be structured and who will control critical board votes. Most commonly, the ideal structure would contain an equal number of VC-friendly members and founder-friendly members, as well as an “independent” board member to play a tiebreaker if the time ever came.

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