eleva8or has assisted several startups in emerging markets to negotiate term sheets (1). Our research has shown that several startups do not have the awareness of what actually encompasses a term sheet. This is by no means a trivial process and should not be taken lightly by startups. The first mistake tends to be simply downloading a standard template without actually understanding what the terms mean. The discussion below is from third party sources and been adjusted as required to target the emerging markets. Due to the large variations across term sheets in emerging markets it was difficult to come up with a common set of issues which are faced by startups in the emerging market community. Hence we have attempted to leverage a broad based discussion which we have found to have common terms in certain emerging market startups – we have tried to focus on emerging markets where a majority of startups are emerging on our platform.
In plain english a term sheet is like a marriage between your company and your investors, but with a lot less romance or open-ended trust. It dictates who gets what financially, and who gets to do what legally, in almost every scenario.
The terms in the term sheet outline the “conditions” for an investment. These terms will describe things like the agreed upon valuation of the company, the price per share for the investment, the economic rights of the new shares and so forth.
Generally, a term sheet itself is not legally binding. Its main purpose is to serve as a blueprint for the formal legal documents that will be drafted by lawyers. However, you usually agree to confidentiality and a promise not to enter into negotiations with other investors at the same time.
Term Sheet Negotiation
Term sheets are essentially all about two things:
1. Control of the company
2. Cash received upon an exit event (the economics)
These elements are at the heart of being a startup entrepreneur, so you absolutely want to understand how different terms affect you. It can be a make-or-break deal for startup founders. Knowing where to negotiate and what to negotiate for is critical, because not all terms are equally important. You want to focus on the components that really matter. And once you successfully negotiate the key terms, the incremental benefit of negotiating other terms diminishes pretty quickly.
“A lack of term sheet knowledge puts you at a serious disadvantage. Academics would call this information asymmetry. Venture capitalists aren’t out to dupe you, but they’re not charity foundations either. In the Darwinian world of startups, only the smartest and most savvy entrepreneurs generally survive.”
Nearly all VCs work hard to maintain positive, long-term relationships with entrepreneurs. But would a rational investor negotiate against themselves? No. They will act rationally in their best interest.
VCs are in the business of making deals, so of course they know all the ins and outs. It’s your responsibility as a founder to educate yourself. Don’t expect your investors to spend time and energy training you to get best possible terms in a negotiation.
Also keep in mind the interpersonal nature of term sheet negotiation. Some entrepreneurs make self-destructive mistakes by ignoring important social and interpersonal dynamics involved with accepting a term sheet. Venture capital is a small world, so avoid burning bridges.
Key Terms – Economics
Valuation (and percentage ownership)
The company’s valuation, along with the amount of money invested, determines the percentage of the company the new investors will own. This is one of the most crucial components of the term sheet, because it has the most direct impact on who owns what and how much cash each shareholder receives when the company sells. Valuation is expressed 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 simply equal to the pre-money valuation plus the amount of the new investment. The founder’s basic objective is to maximize the amount of capital investment while minimizing dilution.
“If investors believe the company is worth $4M, and they want to invest $1M, your pre money is $4M and your post-money is $5M:
Post-money = $4M pre-money + $1M investment
The $1M investment gives investors 20% of the company:
Investor ownership = $1M investment / $5M post-money”
Valuation is arguably the most important component of the term sheet. A poor valuation can ruin a deal even if all other terms are in your favor. However, the inverse isn’t necessarily true. A great valuation doesn’t always outweigh unfavorable terms elsewhere on the term sheet. But many founders don’t know this. They naively assume that a great valuation equates to a great term sheet.
Never make that assumption. VCs can extract more value than the valuation would imply, so the best deal may not always be the one with the richest valuation. Plus, you set a bar for yourself with every future term sheet valuation. And if you haven’t cleared that bar the next time you need to raise money, you put yourself in a very bad position. Flat rounds (raising money at the last valuation) aren’t great, but down rounds (raising money below the last valuation) can literally send a startup into a death spiral.
So approach valuation mindfully. Most entrepreneurs would do best to negotiate a “fair” valuation. This means playing your hand as an entrepreneur who wants to create win-win outcomes for both VCs and founders. It also means keeping your requests in line with your industry and your company’s stage of development.
Entrepreneurs who approach valuation with a level head are more likely to gain a good reputation in the venture community and build strong relationships with investors. If you want to play the game more than once, you have to be a smart negotiator.
Most term sheets will stipulate the creation of an option pool or the expansion an existing one to set aside shares for future hires. The language generally looks something like this:
“Prior to the Closing, the Company will reserve shares of its Common Stock so that [XX]% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.”
The language here is crafted very carefully. The key phrase is, “prior to the closing….” What this means is that the investors want some percentage of the cap table to be set aside for future grants, but they want existing shareholders to absorb all the dilution. The most founder friendly approach would be to calculate the option pool post-money and force the new investors to share in the dilution. But in reality, the standard for most term sheets is to calculate it pre-money, as in the above example. The option pool is a common source of information asymmetry because many founders don’t understand how VCs think about valuation.
The treatment of the option pool can have a significant impact on the “effective valuation” of your company. It affects dilution in a big way and can potentially swing the economics by 5-8% or more.
The liquidation preference is downside protection for preferred stock, and it’s a pretty standard term. Investors would prefer to see your company succeed so their stake in the company is worth more than they invested. But if the company doesn’t do well, a liquidation preference gives them some hope of not losing all their money.
The most standard liquidation preference is 1x invested capital, which means when the company is sold, preferred stock holders are entitled to receive an amount equal to what they invested before more junior classes of stock can receive anything. Or instead, preferred shareholders can convert their shares into common and receive cash according their percentage ownership in the company (if doing so would give them a greater return).
“Anything above a 1x liquidation preference is very non-standard unless your company has become something of a train wreck. If preferred stock has a 2x liquidation preference, this guarantees that investors get twice their money back before common gets anything. Very few deals warrant that kind of preference.
The language for the liquidation preference usually contains something like this:
“In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per-share amount equal to [$X.XXX per share or X times the Original Purchase Price].”
However it’s worded, you’re looking to make sure that the preference is not more than the invested amount.
Also known as “double dipping,” participation rights let preferred stockholders get their money back before anyone else, and then also participate fully (pro-rata) in any remaining proceeds.
To illustrate, suppose preferred stock has a $500k liquidation preference with participation rights and owns 40% of the cap table. If the company sells for $1M, preferred takes $500k off the top and also gets 40% of the remaining $500k for a total payout of $700k. That leaves $300k for common shareholders.
“As you can see, participation rights heavily favor preferred stockholders. In fact, this can be one of the most punishing terms to founders and employees as holders of common stock. While not unheard of, participating preferred stock is definitely not the standard. So don’t hesitate to make a case against it.”
You will likely find the language for participation rights in the liquidation preference section of the term sheet. There will be a phrase that looks something like this:
“After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets of the Company shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on an as-converted-to-Common Stock basis.”
The best scenario for founders is to negotiate for no participation rights at all. If your investors insist on participation rights, a reasonable compromise is to negotiate for a cap on participation, which puts a limit on how much the preferred stockholders can double dip.
Dividends, expressed as a percentage (e.g., 8%), provide an additional return that accrues to preferred stockholders over time. Any dividends that accrue to preferred stock increases the liquidation preference by that amount.
Pretty much all term sheets mention dividends, but depending on the language, the section may be effectively pointless. The most founder friendly dividend language will include the word “noncumulative” and the phrase “when and as declared by the Board of Directors.” With these two features, this term will likely never come into play.
“Watch out for the word “cumulative” or the acronym “PIK,” which stands for “paid in kind.” Cumulative dividends essentially guarantee investors a certain level of return, which is not a very standard feature for early-stage deals. PIK dividends are a double whammy, because the value of the dividend is paid to the investor in the form of additional preferred stock. This not only increases the liquidation preference for preferred stock, but it also dilutes founders simply with the passage of time.”
Anti-dilution is a pretty standard feature of preferred stock. It protects investors from getting grossly diluted in the event of a “down round” (i.e. the Series A round was raised at $2 per share and later a “down round” occurs when the Series B round is raised at $1.50 per share). The math gets complicated, so I won’t cover it here.
Anti-dilution protection comes in several forms: full-ratchet, narrow-based weighted average and broad-based weighted average.
Broad-based weighted average is the most founder friendly form of anti-dilution. Adding a “pay-to-play” provision requires an investor to invest more capital in a down round in order to receive anti-dilution benefits.
In general, you’re mostly safe if anti-dilution is either of the two weighted average varieties.
“Full-ratchet anti-dilution can be pretty devastating to common shareholders in a down round. Hopefully anti-dilution never comes into play. But if it does, full-ratchet can effectively wipe out common stockholders, so avoid it if you can.”
Key Terms – Control
Control of the company is pretty much binary: either you have it or you don’t. There are three main elements of control that have implications for different types of decisions.
Board of Directors
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. In many ways, the board is the most important control mechanism of the typical VC-backed company.
As with other terms, there are more founder-friendly options and less founder-friendly options. The company’s stage makes a big difference in how likely you are to maintain control or not.
Founders often maintain complete control over the boards of early-stage companies. But if they continue to raise money, often the investors (as a group) will have more control than the founders. Many feel that the ideal structure, even for later-stage companies, contains an equal number of VC-friendly members and founder-friendly members, as well as an “independent” board member. The independent member is usually a respected business person who is trusted by all other board members. The primary objective for founders is to make sure that board representation between VCs and founders/common shareholders stays equal. Under these circumstances, both sides have equal voting power. In a situation where the two sides disagree, neither side would be able to win without convincing the independent member to vote in their favor.
Ownership Percentage of Share Classes
Some company decisions depend on a shareholder vote rather than a board vote. For these decisions, voting power comes down to percentage ownership. So the main concern is whether or not majority ownership of the company is held by founder-friendly shareholders or VC-friendly shareholders. A few important company decisions, like stock splits or dilutive issuances, may even require the approval of a majority of each share class, including common and all preferred. In these cases, the more shares you control in each class, the more influence you will have in the vote.
Investors typically require special rights called “protective provisions” before they agree to invest. These special provisions essentially give investors trump cards that apply to very specific company actions.
They can include things like limits on how much debt you can take on without VC consent, restrictions on increasing authorized shares to take on new funding or give to employees, and changes to the certificate of incorporation.
Some provisions are reasonable and fairly standard, other provisions can be way too restrictive. The list of potential provisions is too long to list here, so the best approach is to rely on advice from your lawyer. A good lawyer will be able to catch provisions that could come back to bite you.
Term sheets are complicated, and it can be easy to get hung up on the details. But at the end of the day, there’s probably just a few key terms that you should really care about.
Educate yourself about the consequences of the various terms, and decide with your co-founders and advisors what matters most to you. Because you’re not going to get the most founder friendly arrangement on every term. That’s just not realistic. If you argue with potential investors on every point and resist compromise on every term, you will likely end up without a deal.
Also keep in mind that term sheets in a startup’s early financing rounds can set a precedent for later rounds. Future investors will likely anchor on the terms of the investments that preceded them.
(1) This article is based on information provided to eleva8or by various third party resources which include our interactions with startups on the platform, content provided to us by startups and third party content available to readers of our newsletters who share content with us. eleva8or neither rep or warrant any of the content nor do we claim that the full content is our original research. At eleva8or we choose topics based on the interest of our startup community and encourage them to send us material which may be useful to the community. We recommend to all startups to seek proper advice from qualified individuals during term sheet negotiations.