Investment plays a critical role in backing up as well as making a business stand firmly in the initial stage and pitching your new business or start-up is the most critical exercise you will ever perform, if you wish to secure funding for your business. Amidst the big hullabaloo of pitching your start-up or new business to investors for months, you will finally secure: A Term Sheet (hopefully more than one) from an investor interested in funding you. This guide will try to explain you what exactly is a Term sheet and its implications on your business.
A Term Sheet is perhaps one of the most important documents a founder will ever encounter. It outlines the “Terms and conditions” for an investment. These terms will define things like the agreed upon valuation of the company, price per share for the investment, the economic rights of the new shares and so forth. In addition to these a term sheet may specify some of the options, rights and responsibilities of each party.
Generally, a term sheet itself is not binding. It acts as a blue print for the formal legal documents that will be drafted by a lawyer. However, you do agree to confidentiality to not to enter into negotiations with any other investors at the same time.
A Term Sheet can take many forms, from a single page or up to 7 or 8. And if you are first time entrepreneur, you may come across very confusing terms and conditions. A typical Term Sheet contains following important clauses: –
This is the single most important term in a Term Sheet. The company’s Valuation along with amount of money invested determines the percentage of the company the new investors will own. This has direct Impact on who owns what and how much cash each shareholder shall receive when the company sells.
The valuation of the company is based on pre-money and post-money valuation. A pre-money valuation stipulates the company’s valuation before the investment and post-money valuation is simply pre-money valuation plus new investment.
There is lot of ambiguity regarding valuation. Sometimes a poor valuation can ruin the deal even if other terms were in your favour. But this is not necessarily true, because a great valuation may not guarantee success, if there are unfavourable terms on the term sheet.
Option Pool –
A Term sheet may stipulate the creation of reserve of stock for existing and future employees. Option pool is used as the way of compensating services to the company through stocks.
Many founders calculate the option pool stock after post-money and force the investors to share in the dilution. But the standard for most term sheet should be to calculate it pre-money.
Types of Stocks –
There are usually two types of stocks that are negotiated in the term sheet. Common stock and preferred stock. Common stocks are held by founders and preferred stocks are given to the investors. Preferred stocks come with rights, preferences and privileges, owing to the financial interest that holder this stock has in company.
Liquidation Preference –
Liquidation preference clause is added for the protection of the investors. Investor would want your business to succeed so that their stake in the company is worth more than they invested. But what if your company is not performing well? A liquidation preference gives them some security of not losing all money. It determines the amount of money returned to investors against the original purchase price at the time of the liquidation of the company.
The Term Sheet defines what exactly constitutes a liquidation event. Perhaps it is mergers or acquisition or selling off your company’s assets. It does not mean winding-up or closing down of the company.
Participation Rights –
Participation stipulates who gets a share of the remaining proceeds in liquidation event. The participating right offers following benefits to the preferred stock holders:
Full Participation – This means that a preferred stock holder gets not only their share of preference but also on the left over proceeds alongside the common stockholders.
Capped Participation – The preferred stock holders gets share of the leftovers up to a certain limit.
Non Participation – The preferred stock holders get no shares further share in the leftover proceeds, after the preference is paid.
Dividends, expressed as percentage provide monetary amount to the shareholders by the company. All term sheet includes a dividend clause which lays down the dividends to be paid by the company.
Anti-dilution is one of the most important clause of a term sheet. It protects investors from getting totally diluted in the event of a ‘down round’ i.e. when numbers of shares alter or lowers the price of the share.
Pre-emptive rights –
Pre-emptive rights are given to existing investors to give them preference to participate in the future round of the funding. This ensures that investors maintain the right to maintain their ownership by buying the proportionate numbers of shares of any future issue of the shares.
Board of control –
This clause stipulates that a good mix of investors and promoters will form the part of the Board team. A third party may also be included to give an unbiased and fair decision. A Board observer may also be included at the insistence of the investors.
Vesting period of founders –
Vesting means an ownership on the shares of the company. This clause is generally included to protect the investors in the event where founders exit. This ensures that founders do not invest too much, too soon. The average vesting period is of four years with one-year cliff period.