Term sheets: what are they?
Startup founders and investors use term sheets as their first formal, but non-binding, contract. The terms and conditions of an investment are outlined in a term sheet. Contracts are drafted after final terms have been negotiated.
In the long run, it's better for all parties (including the company) if investors and founders align their interests. Founders and investors are pitted against each other by a bad term sheet.
Take a look at some of the components of a successful term sheet - and let's avoid some of the pitfalls.
How does a term sheet work?
There are specific areas in any startup term sheet that should probably be covered. While each term sheet will differ, it should cover the following.
Can you tell me how much this startup is worth? You must know what you're negotiating before you can negotiate terms.
We have compiled ten real-world methods of valuing an early-stage startup.
There are two types of valuations on a term sheet: pre-money and post-money. In terms of startups, pre-money is the value of the startup before investment, and post-money is what the startup is worth after the investment has been made.
Employees or future employees can reserve shares in an option pool. An option pool might be needed on a term sheet or you might need to expand the one you have already. As stock is issued, you also decide how it gets diluted.
It is unfortunate that pre-money option pools often favor investors, since they make all future dilution the founder's responsibility. Post-money option pools are more founder-friendly because investors will be included in dilution in the future. Pre-money option pools are, however, most common.
c. Preference for liquidation
Investors who acquire preferred stock have a safety net in the form of liquidation preference. Investors are able to get some of their money back in the event of your startup failing.
The benefits of participation rights include two things: First, they receive a return on their investment before anyone else, and second, they receive a percentage of whatever is left over. For example, say an investor who owns 30% of the cap table owns preferred stock with $250k liquidation preference. A $2 million sale gives preferred stock holders $250k up front, along with a 30% stake in the remaining $1.75 million ($525k). For common shareholders and founders, that leaves $1.22 million.
The purpose of dividends is to distribute profits to shareholders of a company. Cash or stock can be used to pay them. Preferred stockholders also receive dividends - it's one of the things that makes these stocks "preferred." Dividends are usually calculated at a percentage over time - between 5% and 15%.
In an early stage company, a Board of Directors may seem absurd, but as a company grows, it becomes increasingly important. The Board of Directors will therefore be included in most term sheets.
g. Shared Ownership percentage
A company's board often makes big decisions, but shareholders can also vote on some decisions. Share class ownership percentage should be included in your term sheet.
Investor rights are usually outlined in term sheets. There are a lot of rights listed here, which is why you should consult a lawyer to ensure you're getting the best deal. The investor has a right to take or expect certain actions based on their investor rights.
