- Raising venture capital isn't easy, but we've made it simpler with our comprehensive guide to understanding the language on a term sheet.
- Below are tips from founders, investors, and lawyers, plus other resources, including a sample term sheet from Andreessen Horowitz managing partner Scott Kupor's book " Secrets of Sand Hill Road."
- It is important to remember: Although a term sheet is not legally binding in itself, it does set the parameters of later contracts and it could shape your future rounds of funding.
- Founders should think long-term and weigh the importance of money versus control. Sky-high valuations aren't always the best thing for a growing company, and different classes of stock come with important obligations.
- The moment you receive a term sheet from an investor is the time to find a lawyer who specializes in these issues.
- Visit BI Prime for more stories.
If you've made it through the pitch process and are at the point where an investor has handed you a copy of a term sheet, you have a right to feel pretty excited.
So give yourself a few minutes to celebrate — and then get down to business.
While a term sheet isn't a legally binding document, it has the potential to shape every future round of funding you raise. It's extremely important to read it carefully, hire a lawyer to help you understand what you just read, and make sure you're comfortable with everything in there before signing your name.
Business Insider spoke with a series of entrepreneurship experts — including founders, investors, and lawyers — about key aspects of the term sheet and the most common pitfalls to avoid. We've also included a sample term sheet at the bottom of this guide, and you can find other templates on the National Venture Capital Association website.
Read on for the best advice we heard about term sheets:
Look at the big picture
It's easy to get bogged down in all the legalese in a term sheet.
But ask Jerry Chen, a partner at the venture-capital firm Greylock Partners, and he'll tell you that the main thing to focus on is the quality of the investor and the firm they work for. If you've chosen someone knowledgeable and experienced, it's unlikely they've included anything deceptive or unconventional in there.
The three key categories of terms to review, according to Chen, are valuation, governance, and voting rights (more on all those below). While other terms are important, they won't have as much of an impact on your company's future success.
Get familiar with the negotiation process
Keep in mind that you won't be drafting a term sheet — the investor will. If you're lucky, you'll have multiple investors vying to be the lead, so you'll receive competing term sheets. The terms you set with your lead investor determine the terms you'll set with other investors participating in the round, said Bouchra Ezzahraoui, a cofounder of the New York jewelry company AUrate, which launched in 2015 and raised $13 million in a Series A funding round in 2019.
So exactly how long does this whole process take? Dave Kimelberg, the managing partner at Kimelberg PLLC, a New York City firm that provides legal counsel to entrepreneurs and investors, said that if your company's in demand, it could take just a week. Otherwise, VCs won't be incentivized to move as quickly, and negotiations might take months.
Know what constitutes business standard
The term "business standard" means "how things are typically done." If something on the term sheet isn't business standard, be sure to ask about it and how it will benefit the company, Ezzahraoui said.
For example, Kimelberg said term sheets today are typically two pages. If an investor sends you a 10-page term sheet, it's on you (and your lawyer) to figure out exactly why.
Then again, you may very well want to deviate from business standard in some portion of the term sheet. If so, you'll need to back that up with supporting evidence, said Jack Kramer, who co-founded the daily finance newsletter MarketSnacks with Nick Martell.
Just because something is business standard "doesn't mean it's how it should be done," Martell said, "There's always room for innovation in finance."
(Kramer and Martell are now managing editors of news at Robinhood, which acquired their business and renamed it Snacks. Meanwhile, Robinhood was recently fined by federal regulators, who said they'd found violations in how Robinhood executed clients' trades, Business Insider's Dan DeFrancesco reported.)
Think long term
Always keep in mind that the term sheet you sign today will influence future fundraising rounds. "That document will tag around for a long time," Ezzahraoui said.
Sacha Ross, a partner at Cooley LLP, a New York City law firm that advises high-growth companies and investors, shared an example of how myopic thinking can come back to haunt a founder. Say you agree to give the VC a 10% cumulative dividend on their investment, meaning every year they receive 10% of their investment.
"A cumulative dividend of 10% for a $1 million raise may not be that impactful," Ross wrote in an email to Business Insider. "But if that dividend is carried through to a $300 million growth round, the preference can build quickly."
Ezzahraoui also advises founders to know where they want their company to go in two to five years, including the investors they want to target in their next fundraising round and what those investors primarily care about. She encourages founders to think about whether their current term sheet presents any obstacles to landing those future investors.
Remember this is the beginning of your relationship with investors
"There's this tendency to think of the fundraising as the milestone moment, as the capstone," Martell said. "The reality is that the fundraise is where the work just gets started."
Chen said the negotiation around the term sheets gives you a glimpse into what it would be like working with the VC going forward. It's the only time when you and the investor will be on opposite sides of the table, so you'll get to see how they conduct business.
Educate yourself and seek legal counsel
As a first-time founder, you should absolutely seek legal counsel during the fundraising process.
"If you are going to spend money on legal," said Megan O'Connor, the cofounder and CEO of Clark, "this is the time to do it." The tutoring-software company, based in New York, launched in 2016 and has raised $3.5 million in angel and seed funding rounds.
Ezzahraoui added that it's important to do your own research — reading the literature, talking to other founders — even before meeting with your lawyer, so you know which questions to ask. And of course, don't be afraid to ask those questions. "You have to be confident enough in yourself to show when you're not confident," Martell said.
A word of caution: Patrick McGinnis, a serial entrepreneur who's the managing partner at Dirigo Advisors, an independent advisory firm, said lawyers can miss things too.
"You must read everything extraordinarily carefully, and you must do all the math yourself and make sure all the math works out," McGinnis said.
Another option is to ask the investor you're considering partnering with to give you a copy of a typical term sheet. It doesn't have to include exact numbers, but it could give you an idea of what it looks like so you're not caught by surprise or pressured to respond quickly, Chen said.
Plus, Ross said that "showing that you as a founder understand what's important to you, and want to know what's important to your investor, establishes your credibility."
Take the document seriously
A term sheet is not legally binding. Typically, the founders' and investors' lawyers will use the term sheet to draft other, legally binding documents, including stock-purchase agreements and shareholder agreements.
But as Martell warned, don't think you can change something when you get to the real contract.
"Once you agree to the term sheet, those are the general principles you're agreeing to, and nothing should be in conflict with what's in the contract," he said.
Weigh the importance of money versus control
In their 2016 book, "Venture Deals," Brad Feld and Jason Mendelson, cofounders and managing directors at Foundry Group, which invests in early-stage technology companies, wrote that VCs care primarily about economics (the return they'll get in a liquidation event, like an initial public offering or acquisition) and control (their ability to veto founders' decisions and shape the fate of the business).
Feld and Mendelson wrote that if a VC is preoccupied with any terms beyond the scope of economics and control, that shows you how nitpicky they might be down the line.
As for prioritizing money or control, Ezzahraoui said that sometimes you'll want to go with the investor at a lower valuation if they add more value to the business or if the term sheet positions you for a higher valuation in the future. As a founder, you have a fiduciary duty to keep the best interests of the company in mind, she said.
"Founders can get a little 'valuation hungry,'" O'Connor said, but it's also important to consider terms like dilution and future acquisition price. "Higher doesn't always mean better."
Pay attention to the liquidation preference
"Liquidation preference" outlines how the proceeds will be shared in a liquidity event. According to "Venture Deals," it's among the most important terms in a term sheet.
Capshare's guide to term sheets breaks down the standard practice: When a company is sold, preferred stockholders are entitled to an amount equal to what they invested before other stockholders receive anything at all. Preferred shareholders can also convert their shares into common stock and receive cash instead.
Beware of ratchet mechanisms
Ratchet mechanisms have become increasingly common in venture deals, especially when investors are backing companies with an unproven business model and when those companies are burning through cash.
If the company goes public below the valuation that founders and investors agreed on, the company must issue its preferred shareholders additional shares so those investors don't lose money.
For example, in WeWork's S-1 filing, the company reported it had a partial ratchet mechanism in its deal with Softbank, which Renaissance Capital projected could have resulted in the world's largest-ever IPO ratchet.
Renaissance calculated that if WeWork went public in September 2019 at a market cap of less than $14.5 billion (it didn't go public at all), WeWork would have had to issue Softbank shareholders more than $400 million worth of additional stock.
That would be a tough pill for a founder to swallow after a botched IPO.
Keep in mind the size of your option pool
Your "option pool" is the amount of equity you can grant future employees. The size of the option pool (typically between 10% and 20%) is taken into account in the company's valuation, according to "Venture Deals" — meaning a bigger option pool isn't necessarily advantageous.
Feld and Mendelson recommended preparing an option budget for your negotiation with an investor, listing all the hires you plan to make between now and the next round of financing and how much equity you'll offer them.
Consider board dynamics
Kimelberg encouraged early-stage founders to keep control of their board (meaning a majority of seats) and to keep it small. A three-person board is advisable, he added, typically with two representatives nominated by common shareholders and one representative for the preferred shareholders.
Whatever you do, make sure there's an odd number of seats, to avoid deadlock.
Review protective provisions
The protective provision outlines how much control VCs have over your company. For example, you might need their permission to sell the company, raise another round, issue more stock, or declare bankruptcy.
Kimelberg said the voting-majority threshold shouldn't be too high — in other words, "you don't want to have to chase down 70% of all the stockholders to get approval" for a certain decision. What's more, Kimelberg added, the protective provisions in this term sheet will set a precedent for your next round of financing.
Bring up any employment issues
"Any material employment issues, I would also throw into the term sheet, make sure they're there, so that you've surfaced them," McGinnis said. For example, if you're the founder of another company, the term sheet might indicate you'll spend 10% of your time there.
If you don't have any side projects but that paragraph is in the term sheet anyway, it's possible the investor suspects you've got something else going on, according to "Venture Deals."
Use this checklist summary of the most common features
It can be hard to keep all of these terms straight when reviewing a term sheet that you worked so hard to land. Here are five things you won't want to miss:
- Company valuation — The first order of business is making sure the numbers are a right fit for your business right now. Two offers may involve the same amount of money, but it's the percentage of ownership that determines your company's valuation.
- Option pool — What percentage of shares will be available to help recruit and compensate your team?
- Board seats and voting rights — How much control are you willing to grant to investors? And how will those early decisions look in the future as your company scales up?
- Liquidation preference — If your business fails, preferred shareholders are typically first in line after creditors and bond-holders to get their money back. You may be able to negotiate an agreement that is more favorable to your company, and you should make sure you're not on the hook for more than is being invested.
- Closing conditions and deadline — What due diligence must be performed to secure the deal? And how quickly do you have to decide?
Here's how it would look if term sheets were written in plain English.
Check out this sample term sheet
This document, which is included in the book "Secrets of Sand Hill Road" by Andreessen Horowitz managing partner Scott Kupor, is an example of what you might find on a standard term sheet.
This one won't show specific names or numbers.
Scott Kupor's sample te... by on Scribd
SEE ALSO: The first-time founder's ultimate guide to understanding stock options
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