Term Sheets, Their Importance & Intricacies

Upon generating interest from prospective investors during your capital raise, it is best to be armed with the necessary information/documentation to turn that interest into a transaction. The document that constitutes the first step in that direction is your term sheet.

What is a term sheet?

A term sheet is an informal non-legally binding document that outlines the terms and conditions between an investor and founder. The reason term sheets exist is so that both parties, investors, and founders, can grasp a high level understanding of the deal, serving as a precursor/blueprint for the more formal and legally binding shareholders agreement to be drafted.

What is the purpose of a term sheet?
  • Establishing a level of understanding to ensure an agreement between the investor and founder on most aspects, effectively reducing the chances of a dispute further into the negotiation process.
  • Ensuring founders do not prematurely incur the legal costs associated with drawing up a legally binding agreement, only to be changed or become redundant later.

It goes without saying, you want this sheet to attract not deter prospective investors, whilst also ensuring the deal is fair and structured in a way that protects your upside potential and downside risk.

We’ve outlined the main components of a term sheet below distinguishing between founder-friendly and investor-friendly options.

Parts of a term sheet

  • Valuation

The valuation of the company is how the investor can calculate what they will receive in return for funding your venture.

Valuations to be displayed include:

Pre-money – Company’s valuation before any new investment.

Post-money – Pre-money valuation plus any additional investments that come in.

Example: Company A is raising $250,000 at a $3,400,000 pre-money valuation. After a successful raise Company A has a post-money valuation of $3,650,000.

It is important to indicate to an investor whether the valuation is pre or post money in order for them to determine the equity they will be receiving in return.

  • Option Pool

Some term sheets will include the stipulation of an option pool or expanding an existing one. An option pool includes shares set aside for future hires of the business in the form of equity stock options.

Something investors may include in this section is the phrase “prior to the closing” or pre-money which means they want a percentage of shares from the existing cap table to be set aside for the option pool which would mean only the existing shareholders will experience dilution.

Founders, however, may calculate the option pool post-money which would mean the new investors also experience dilution whilst minimising the dilution of existing shareholders.

  • Liquidation Preferences

Liquidation preferences are a provision known as ‘preference shares’ that serve as a protection for investors in the event of the venture failing, leading to an earlier than expected liquidation. It basically determines the order and amount investors are paid out in this scenario.

There are different types of liquidation preferences to be offered, here are briefs on the main ones:

1xInvested Capital – this is the most common and ensures investors receive the exact amount they invested into a venture upon liquidation ahead of any junior classes of shareholders, if the liquidation results in a less than the invested amount, they will receive the entire payout.

Participating vs. Non Participating – Non-participating shares with a 1x Liquidation preference will mean that upon a liquidation event, the investor will have the option to either:

i) Cash in on their shares for the amount they invested in, or
ii) Convert their shares into common stock and then cash out.

For example, if a company sells for $1 million, and the investor initially invested $1 million for 20%, they can, using the option:

i) Exercise their liquidation preference and receive $1 million back, or
ii) Convert their equity to common stock, which would be 20% of the $1 million, which would amount to $200,000.

In this instance, it would make sense to go with option (i).

However, what if the company liquidated/sold at $10 million? Then the options would be to take $1 million, or to convert common stock of 20% equity which would convert to $2 million. As you can see, this is an investor – friendly option, and one many VC’s/Angel’s may include in the term sheet.

Participating shares with a liquidation preference are when an investor, upon a liquidation event, will not only be paid back their liquidation preference but also receive additional participation. This additional participation is a percentage directly proportional to their guaranteed liquidation preference.

So, an investor who had initially invested $1 million for 20%, with a liquidation preference of 1X, would, upon the company selling for $2 million, receive their guaranteed $1 million, as well as 20% of the $1 million, which would amount to $200,000. Making the total payout $1,200,000.

Both these preferences are investor-friendly with non-participating being the more common version. It is good to know what each entails when reviewing terms given to you by the investor.

  • Dividends

Dividends, which is any additional return paid over time to investors, can either take the form of cumulative or paid in kind (PIK).

Cumulative – is a guarantee of a specific level of return to investors, which must be paid by the issuer of stock either at the due date, or later date. If it’s not paid when it is due, they are still obliged to pay at a future date, possibly with an additional interest.

PIK – or paid in kind dividends, are when the value of a predetermined dividend is paid to the investor in the form of additional preferred stock. This can increase the liquidation for the preferred stock of the investor, but also may dilute the ownership of the founder’s stake.

  • Anti-dilution

Anti-dilution, another feature of preferred stocks, protecting investors from being diluted in the event of a down round. A down round refers to a round of raising capital at a lower valuation than previously set.

  • Board of Directors

The board of directors is an important consideration for founders as it is a body of crucial and controlling governance over any company. Term sheets include both the structure of the board and the allocation of critical board voting power. What you have to look out for as a founder is losing controlling votes. Typically, VC-backed businesses will attain board seats as a way to ensure oversight over their portfolio companies. Early stage founders may, at first, maintain control, but as they continue to raise capital, that control begins to disseminate amongst new investors that come on board. 

Therefore, it is in the best interest of the founder to ensure an equally representative board, investor-friendly members, founder-friendly members, and independents. Similar to that of a government. This way, both parties have advocates at the highest levels of decision making, and, in the case of a hung decision (equally opposing votes) the independents would ideally make an unbiased call. 

So you’re aware, the decisions that board members typically make include:

  • Hiring and firing of senior management
  • Dividend policies
  • Executive compensation and salary increases/key new hire decisions. 
  • Budget approval
  • Adherence to company goals/mission
  • Equity/debt financing decisions
  • Ownership Percentage of Share Classes

Sometimes business decisions lie outside the board, and instead the voting power is in the hands of shareholders. The level of control is usually determined by ownership percentage. Therefore, like that of the board, it is important to keep a watchful eye on the percentage ownership amongst investor-friendly and founder-friendly shareholders. 

Decisions made by shareholders require a shareholders resolution, meaning that 75% of shareholders must  agree for a resolution to be passed. 

Typical decisions made by shareholders include:

  • Changing the name of the company
  • Adopting, repealing, or modifying the constitution
  • Changing the type of company. For example, from a private to a public company
  • Approving a selective buy-back of shares by the company
  • Selectively reducing share capital
  • Transferring the company’s registration to another state or territory
  • Winding up the company
  • Converting ordinary shares to preferences shares and vice versa.

In conclusion, it is important to ensure that your term sheet, as a founder, is strategically drafted to protect your interest not only in the immediate future but also as the business grows. Ensuring these protective measures are in place will save you the headache and turmoil that comes with the inevitable less cohesive moments in the founder-investor relationship. 

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