Investment term sheets outline the terms and conditions of an investment before the final terms of the contract are negotiated. An investment term sheet is the first formal, but nonbinding contract used by startup founders and investors.
The company (and investors) will benefit when investors and founders align their interests. Poor term sheets pit investors and founders against each other.
There are a number of components that make up a term sheet – let’s examine a few of those components and avoid some of the common pitfalls that occur.
How does a term sheet work?
In startup term sheets, there are a few important topics that should be addressed. They may differ from one startup to the next.
Understanding what you are negotiating is the first step in negotiating terms.
It has been our pleasure to compile a real-world analysis of startup valuations.
Pre-money valuations are included in investment term sheets, along with post-money valuations. The pre-money valuation is an estimate of how much a startup is worth before investment, while the post-money valuation is an estimate of how much it is worth after investment.
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b. Pools of options
The size of your option pool can be expanded or you may need to create one if you do not already have one, and you may need to decide whether or not your company wishes to dilution it share price over time.
It is common to use pre-money option pools, both because they favor investors and because they impose a liability on founders for future dilution. Post-money option pools are more founder-friendly since investors will also be included in any future dilution.
c. Liquidation is preferred
Preferential stock holders are guaranteed a liquidation preference in the event your startup fails.
- Participation rights
In addition to receiving a return on their investment, participation rights holders also get a share of the profits before anyone else. For example, a preferred stockholder holding 30% of the cap table with $250k liquidation preference will have $250k liquidation preference. The preferred stock holders receive $250k up front and 30% ownership of the remaining $1.75 million ($525k), leaving $1.22 million for the founders and shareholders.
- Amounts distributed
As part of the process of doing business, a company often distributes its profits to the shareholders. These dividends can be paid in cash or in stock, and they are often an integral part of what makes these stocks so popular. Dividends are usually calculated at a percentage over time – between 5% and 15%.
f. Board of directors
At the beginning of a business, you might think that including a Board of Directors in a term sheet is meaningless, however, as the company grows, the Board becomes increasingly important in the overall operations of the company.
g. Percentage of shareholders
It is important to include a share class ownership percentage in your term sheet just in case. Shareholders are also able to make decisions through voting on some of the board’s decisions.
h. An investor’s rights
Term sheets usually outline a detailed list of investor protections in a very detailed manner. Many rights are listed in these documents, so if you are asked to take any action, it is best to consult with a lawyer. Investors are entitled to take certain actions based on their investor rights.